Discounted Cash Flow Model Flashcards
Difference between equity value and enterprise value
Enterprise value is the sum of a company’s market capitalization and its debts, minus the cash and cash equivalents it holds. It accounts for a company’s current stocks, debt and cash
Equity value uses the same calculation as enterprise value, but it adds in stock options, convertible securities, and other potential assets and liabilities. Because it considers factors that may not currently impact a company, but can at any time, equity value reveals a company’s potential future value and its growth potential
Calculating WACC
multiply the fraction of the capital structure that is funded with debt by the the cost of debt and the tax rate and then we add that to the fraction of the capital structure that is funded by equity and multiply that by the cost of equity
What is the downside of WACC in the DCF?
we use the same WACC throughout the DCF analysis
- so we are assuming that the company being valued maintains a stable capital structure
(WACC) What is the equity weight for public companies?
market value of equity
- diluted shares x market share price
(WACC) What is the equity weight for private companies?
use the equity value that we get when we do the DCF, use that equity value to find what the WACC is. But that creates a circularity because WACC is used to derive that very equity value that we are using. Insert a circuit breaker
(WACC) What is the debt weight ?
- book value of debt as an estimate for market value of debt
- if interest rates have changed a lot since debt issuance, dont use book value, instead use the market price of the company’s debt if is actively traded
(WACC) What is the cost of debt for public companies?
- directly observable in the market as current yield-to-maturity on the company’s long-term debt
(WACC) What is the cost of debt for private companies?
- use yield of debt with similar credit rating
use credit agencies such as Moody’s and S&P which provide yield spreads over US treasuries by credit rating
(WACC) Why do we multiply the cost of debt by (1-tax rate)
- the true cost of debt is the after-tax rate because of the ability of interest expense to shield taxes
- because of the tax deductability of interest expense, it decreases the cost of debt because interest expense reduces earnings
(WACC) What is the cost of equity?
- represents the expected rate of return for equity investors
- the bigger the risk, the higher the expected return will be
- not directly observable
(WACC) What model is mostly used to calculate cost of equity?
Capital Asset Pricing Model (CAPM)
(WACC) What are the steps used in CAPM to calculate cost of equity?
CAPM divides risk in 2 types
1. Unsystematic risk ( company-specific) which is the risk that is ignored because this risk can be diversified and canceled out
ex: steve jobs leaving apple
2. Systematic risk: most important risk. Refers to company’s sensitivity to the market changes. Type of risk company cannot ignore or diversify away from. Investors demand return for assuming this type of risk
Cost of equity = risk free rate + Beta x ERP
Beta = systematic risk
ERP = Equity risk premium, risk of investing in equity class
Unsystematic (company-specific) risk
- risk that can be diversified away so ignore this risk.
- ex: if you are looking to invest in Apple and the idea that something company-specific with Apple might go wrong. Like Steve Jobs leaving Apple. Thats company-specific risk and are ignored, that risk you can get over and cancel it out.
Systematic Risk
most important risk to focus on
- Its the company’s sensitivity to market changes
- risk that the company cannot ignore and cannot diversify away from
- investors will demand returns for assuming this risk
What assets would you expect to carry a beta of 0?
U.S. treasuries and cash
