Discounted Cash Flow Analysis

Question 1

5 Steps of a DCF

Answer 1

1) Study target and determine key performance drivers
2) Project Free Cash Flow
3) Calculate WACC
4) Determine Terminal Value
5) Determine Valuation

Question 2

Key Performance Drivers

Answer 2

Performance: Sales growth, Profitability, FCF generation

Internal drivers: New facilities/stores, new products, new customer contracts, improving operational / working capital efficiency

External Drivers: acquisitions, end market trends, customer buying patterns, macroeconomic factors, legislative/regulatory changes

Question 3

Free cash flow

(Description)

Answer 3

Cash generated by a company after paying all cash operating expenses and associated taxes, as well as the funding of capex and working capital requirements, but prior to payment of interest expense.

Independent of capital structure as it represents cash available to all capital providers.

Question 4

Free Cash Flow

(Calculation)

Answer 4

EBIT

• Taxes

= EBIAT

+ D & A (non-cash expense)

• CapEx
• Increase (Decrease) in Net Working Capital

= Free Cash Flow

Question 5

Depreciation

Answer 5

Non-cash expense that reduces the book-value of a company’s asset over its useful life, and reduces reported earnings.

Can be straight-line or accelerated.

Question 6

Amortization

Answer 6

Reduces the book value of definite life intangible assets (as opposed to tangible assets), such as copyrights, licenses, patents, trademarks, intellectual property. These intangible assets are amortized over determined useful life.

Not amortized are indefinite life intangibles such as goodwill (value paid in excess of book value of an asset)

Question 7

Net working capital

Answer 7

Measure of how much cash a company needs to fund its operations on an ongoing basis.

Non-cash current assets -

non-interest bearing current liabilities

Question 8

Current assets

Answer 8

• Accounts Receivable
• Inventory
• Prepaid Expenses and Other current assets

Question 9

Current liabilities

Answer 9

• Accounts payable
• Accrued liabilities
• Other current liabilities

Question 10

Accounts receivable

Answer 10

Amounts owed to a company for its products and services sold on credit.

Measured as “Days Sales Outstanding” (DSO)

DSO = (A/R / Sales) x 365

Company wants to minimize DSO, as increase in A/R is a use of cash, i.e. reduces FCF

Question 11

Inventory

Answer 11

Raw materials, work in progress, and finished goods held by company.

Measured as Days Inventory Held (DIH).

DIH = (Inventory / COGS) x 365

Question 12

Prepaid expenses

Answer 12

Payments made by a company before service or product is delivered.

e.g. insurance premium

Question 13

Accounts payable

Answer 13

Amounts owed by a company for products and services already purchased. Measured as “Days payable outstanding” (DPO)

DPO = (A/P / COGS) x 365

Companies want to maximize DPO, since increase in A/P is a source of cash, i.e. increases free cash flow

Question 14

Accrued Liabilities & Other Current Liabilities

Answer 14

Expenses such as salaries, rent, interest, and taxes that have been incurred by a company but not yet paid.

Question 15

Weighted Average Cost of Capital

Answer 15

WACC = w_d r_d (1-t) + w_er_e

w_d,w_e : relative weights of debt & equity in target capital structure (D/D+E , E/D+E)

r_d: pre-tax cost of debt

t: tax rate

r_e : cost of equity

Question 16

Cost of debt

Answer 16

Reflects company’s credit profile

For publicly traded issues, use current yield on all outstanding issues

For private debt, consult with in-house DCM specialist, use comparable public debt issues, infer implied cost of debt from credit ratings

Question 17

Cost of equity

Answer 17

Use CAPM

r_e= r_f + ß [r_M - r_f]

r_f : Risk-free rate, e.g. 10-year Treasury

ß: measure of asset’s systematic / market risk

r_M - r_f : Market Risk Premium (around 6.62%)