DCF - BIWS

Question 1

What is a Discounted Cash Flow Statement? (DCF)

Answer 1

Analyzes what a company is worth based on the present value of its future cash flows. Future cash flows must be discounted because of TVM.

It is divided into two sections: the projection period (near future) and the terminal value (distant future).

Steps:

1. Project a company’s FCF over a 5-10 year period.
2. Calculate the company’s Discount Rate, usually using WACC (weighted average cost of capital)
3. Discount and sum up the company’s FCF.
4. Calculate the company’s Terminal value.
5. Discount the terminal value to its present value.
6. Add the discounted FCF and discounted terminal value.

Question 2

What is the FCF formula?

Answer 2

FCF = Net Income + Non-cash Expenses - Increase in Working Capital - Capital Expenditure

Question 3

How does issuing equity “cost” the company?

Answer 3

1. If the company issues dividends to common shareholders, it’s an actual expense.
2. By issuing equity to other parties, the company is giving up future stock price appreciation to someone else rather than keeping it for itself.

Question 4

How is cost of equity calculated?

Answer 4

Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta

The RFR = interest earned in ‘risk-less’ security, like 30 year US T bills.
Equity Risk Premium = extra yield you could earn by investing in an index that tracks the stock market in your country of choosing. No one knows what this should be. 2-3%.
Beta = Refers to the riskiness of this company relative to all others in the stock market. If Beta = 1, that means the company is just as risky as the index. If index goes up 10%, the stock goes up 10%. If Beta = 2, the company is twice as risky. Historical Beta can be used for this.

Question 5

How is unlevered Beta calculated and what is it?

Answer 5

Unlevered Beta = Levered Beta / (1+(1-Tax Rate) * (Debt / Equity Value))

Removes the additional risk from debt.

Question 6

How is WACC Calculated?

Answer 6

WACC = Cost of Equity * % Equity + Cost of Debt * & % Debt (1 - Tax Rate) + Cost of Preferred Stock * % Preferred Stock

Determining the cost of each part of a company’s capital structure and then calculating a weighted average based on how much equity, debt and preferred stock it has.

Question 7

Which discount rate is used when using Unlevered FCF vs. Levered FCF?

Answer 7

Unlevered FCF (FCF to Firm): WACC is used because you care about all parts of the company’s capital structure: debt, equity, preferred - because you’re calculating enterprise value which includes all investors.

Levered FCF (FCF to Equity) = Cost of Equity is used as the discount rate because you only care about equity investors and you’re calculating equity value rather than enterprise value.

Question 8

How do equity, preferred stock and debt all affect WACC?

Answer 8

Debt - almost always pushes WACC down because the cost of debt is almost always lower than the cost of equity… Interest rates on debt are lower and the interest rate is tax deductible.
Preferred Stock - Generally cheaper than equity, but not as cheap as debt. Because preferred dividends are not tax deductible.
Equity - tends to “cost” the most

Question 9

How is cost of equity affected by risk free rates, equity risk premiums and debt?

Answer 9

RFR & RFP: Always increase CoE

Debt also increases CoE. If a company has debt, its equity becomes riskier.

Question 10

How is terminal value calculated?

Answer 10

1. assume the company gets sold for a certain multiple… ie, EBITDA multiple.
2. assume it keeps operating indefinitely and sum cash flows (Gordon Growth method) to calculate out into perpetuity.

Question 11

What are the rules of thumb for Cost of equity?

Answer 11

1. Smaller companies generally have higher Cost of Equity than larger companies because expected returns are higher.
2. Companies in emerging markets also tend to have higher Cost of Equity.
3. Additional debt raises the Cost of Equity.
4. Additional equity lows the Cost of Equity because the percentage of debt in a company’s capital structure decreases.

Question 12

Walk me through a DCF?

Answer 12

First, you project a company’s financials using assumptions for revenue growth, margins, and the Change in Operating Assets and Labilities, then you calculate FCF for each year, which you discount and sum up to get to the Net present value. The discount rate is usually WACC. Once you have the PV of FCFs, you determine the company’s terminal value using the Gordon Growth method. Add the two together to determine the company’s enterprise value.

Question 13

How do you get from revenue to FCF in projections?

Answer 13

If referring to unlevered FCF, then:

Subtract cost of goods and operating expenses from revenue to get operating income. Then, multiply by 1-Tax Rate… Add back Depreciation, Amortization and other non-cash charges, and factor in the changing in operating assets and liabilities. Finally, subtract CapEx to calculate unlevered FCF.

Question 14

What is the point of FCF?

Answer 14

Shows only recurring predictable items

Question 15

How do you calculate WACC?

Answer 15

Basically calculate the weighted average of the cost of each portion of a company’s capital structure. So for ex. Cost of equity X the percent of equity, Cost of Debt X percent of debt, Cost of Preferred X percent of preferred…

Question 16

How do you determine a firms optimal capital structure and what does it mean?

Answer 16

Combination of debt, equity and preferred stock that minimizes WACC. No mathematical solution.. Debt is cheapest but obviously can’t use all debt.

Question 17

If a company has a high debt balance and is paying off a significant portion of its debt principal each year… How does that impact a DCF?

Answer 17

Debt isn’t accounted for in an unlevered DCF because interest expense and debt repayments are ignored. In a levered DCF, it would be factored in by reducing the interest expense each year as debt goes down and also by reducing free cash flow.