Error Log DCF IBV

Question 1

What is a DCF/can you walk me through a DCF in under 60 seconds?

Answer 1

“In a DCF analysis, you value a company with the Present Value of its Free Cash Flows plus the Present Value of its Terminal Value.

You can divide the process into 6 steps:

1. Project a company’s Free Cash Flows 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 Free Cash Flows.
4. Calculate the company’s Terminal Value.
5. Discount the Terminal Value to its Present Value.
6. Add the discounted Free Cash Flows to the discounted Terminal Value.”

Question 2

How would you change a DCF to value a highly speculative technology company?

Answer 2

• May employ a longer projection period (may take longer for company to reach “steady state” of cash flows)
• May use a much higher Discount Rate
• You may also adjust management’s growth or profit expectations

Question 3

Tell me 3 places where taxes affect a DCF

Answer 3

• Calculating Beta (conversion from unlevered to levered)
• Calculating FCF (NOPAT)
• Calculating Cost of Debt (interest is tax deductible)

Question 4

A company buys a factory for $100 in its 4th year. How would the DCF/Enterprise Value change for the company?

Answer 4

• Include additional CapEx spending of $100 in Year 4 of the DCF, which would reduce Free Cash Flow for that year by $100.
• The Enterprise Value, in turn, would decrease by the present value of $100 in Year 4.
• You would calculate the difference by dividing $100 by ((1 + Discount Rate)^4). Then you would subtract this amount from the Enterprise Value.

Question 5

What is WACC, conceptually? How do you calculate it?

Answer 5

• The Discount Rate therefore reflects not just the time value of money, but also the return that investors require before they can invest.
• It also represents the “risk” of a company, because higher potential returns correspond to higher risk.
• Can be thought of as the “opportunity cost of capital”
• You’re 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.
• WACC = Cost of Equity % Equity + Cost of Debt % Debt (1 - Tax Rate) + Cost of Preferred Stock % Preferred Stock

Question 6

What are common alterations that one can make to the basic WACC formula to make it more company-specific?

Answer 6

The basic WACC formula is a fairly generic formula that can be improved upon by accounting for nuances in a company’s business model or capital structure. A couple of examples for making it more company-specific include:

● If assessing a private company or a company with a small market capitalization, one could add a size premium or a liquidity discount. This can be accomplished simply by multiplying the entire WACC by a %, with typical discounts ranging from 15 - 30%

● On top of the standard vehicles of debt and equity, a company may employ preferred shares in their capital structure. One can account for this in the WACC by adding another component to the equation of cost of preferred shares x preferred shares’ composition of total capitalization

● If a company recently IPO’d, there may be no historical beta available. Similarly, if a company has no true comparables, using beta to derive cost of equity may not be appropriate. If possible, using the DDM formula to calculate cost of equity would improve the WACC formula for these companies, provided that it has a predictable dividend policy

Question 7

In a DCF valuation, which of the following 3 actions increases the valuation the most: a $10 decrease in capital expenditures, a $10 decrease in expenses or a $10 increase in revenues?

Answer 7

All three of these changes will increase the calculated value in a discounted cash flow model, as they either decreases cash outflows or increase cash inflows. However, some of these changes would not move in isolation and would not necessarily result in an increase in company value of $10. The ranking of attractiveness is as follows:

● First would be a decrease in capital expenditures because it is a direct cash use and there is no tax deduction component. Decreasing capital expenditures by $10 directly improves the value of a company by $10, although it is arguable that it may hurt the ability to generate cash flows in the future

● Second would be a decrease in expenses because is only affected by tax. Flowing through an income statement, you would get a direct increase in value equal to $10 * (1-t)

● Third would be an increase in revenues because any generation of revenues requires associated COGS. In addition to COGS, gross profit would also be subject to tax, making this impact on valuation lower

Question 8

How would raising $100M debt in Year 3 affect the DCF valuation of a company?

Answer 8

Within the context of a DCF, the amount of debt you have directly impacts the WACC formula. Accordingly, you could change the WACC formula for periods after Year 3 and discount cash flows beyond that at the new WACC. Note that the other component of the DCF valuation is based on unlevered free cash flows, so additional interest from any raised debt will not affect them.

Question 9

What’s an alternate way to calculate Free Cash Flow aside from taking Net Income, adding back Depreciation, and subtracting Changes in Operating Assets / Liabilities and CapEx?

Answer 9

Take Cash Flow From Operations and subtract CapEx - that gets you to Levered Cash Flow. To get to Unlevered Cash Flow, you then need to add back the tax-adjusted Interest Expense and subtract the tax-adjusted Interest Income. Tax adjusted interest expense = interest * 1- tax rate

Question 10

How do you get to Beta in the Cost of Equity calculation?

Answer 10

You look up the Beta for each Comparable Company (usually on Bloomberg), un-lever each one, take the median of the set and then lever it based on your company’s capital structure. Then you use this Levered Beta in the Cost of Equity calculation.
For your reference, the formulas for un-levering and re-levering Beta are below:

Un-Levered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Total Debt/Equity)))
Levered Beta = Un-Levered Beta x (1 + ((1 - Tax Rate) x (Total Debt/Equity)))

Question 11

How do you calculate the Terminal Value?

Answer 11

You can either apply an exit multiple to the company’s Year 5 EBITDA, EBIT or Free Cash Flow (Multiples Method) or you can use the Gordon Growth method to estimate its value based on its growth rate into perpetuity.
The formula for Terminal Value using Gordon Growth is: Terminal Value = Year 5 Free Cash Flow * (1 + Growth Rate) / (Discount Rate - Growth Rate).

Question 12

Why would you use Gordon Growth rather than the Multiples Method to calculate the Terminal Value?

Answer 12

In banking, you almost always use the Multiples Method to calculate Terminal Value in a DCF. It’s much easier to get appropriate data for exit multiples since they are based on Comparable Companies - picking a long-term growth rate, by contrast, is always a shot in the dark.
However, you might use Gordon Growth if you have no good Comparable Companies or if you have reason to believe that multiples will change significantly in the industry several years down the road. For example, if an industry is very cyclical you might be better off using long-term growth rates rather than exit multiples.

Question 13

How do you select the appropriate exit multiple when calculating Terminal Value?

Answer 13

Normally you look at the Comparable Companies and pick the median of the set, or something close to it.
As with almost anything else in finance, you always show a range of exit multiples and what the Terminal Value looks like over that range rather than picking one specific number.
So if the median EBITDA multiple of the set were 8x, you might show a range of values using multiples from 6x to 10x.

Question 14

Which method of calculating Terminal Value will give you a higher valuation?

Answer 14

It’s hard to generalize because both are highly dependent on the assumptions you make. In general, the Multiples Method will be more variable than the Gordon Growth method because exit multiples tend to span a wider range than possible long-term growth rates.

Question 15

What’s the flaw with basing terminal multiples on what public company comparables are trading at?

Answer 15

The median multiples may change greatly in the next 5-10 years so it may no longer be accurate by the end of the period you’re looking at. This is why you normally look at a wide range of multiples and do a sensitivity to see how the valuation changes over that range.
This method is particularly problematic with cyclical industries (e.g. semiconductors).

Question 16

How do you know if your DCF is too dependent on future assumptions?

Answer 16

The “standard” answer: if significantly more than 50% of the company’s Enterprise Value comes from its Terminal Value, your DCF is probably too dependent on future assumptions. In reality, almost all DCFs are “too dependent on future assumptions” - it’s actually quite rare to see a case where the Terminal Value is less than 50% of the Enterprise Value.
But when it gets to be in the 80-90% range, you know that you may need to re-think your assumptions…

Question 17

What’s the relationship between debt and Cost of Equity?

Answer 17

More debt means that the company is more risky, so the company’s Levered Beta will be higher - all else being equal, additional debt would raise the Cost of Equity, and less debt would lower the Cost of Equity.

Question 18

Cost of Equity tells us what kind of return an equity investor can expect for investing in a given company - but what about dividends? Shouldn’t we factor dividend yield into the formula?

Answer 18

Trick question. Dividend yields are already factored into Beta, because Beta describes returns in excess of the market as a whole - and those returns include dividends.

Question 19

How can we calculate Cost of Equity WITHOUT using CAPM?

Answer 19

There is an alternate formula:
Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends
This is less common than the “standard” formula but sometimes you use it for companies where dividends are more important or when you lack proper information on Beta and the other variables that go into calculating Cost of Equity with CAPM.

Question 20

Two companies are exactly the same, but one has debt and one does not - which one will have the higher WACC?

Answer 20

This is tricky - the one without debt will have a higher WACC up to a certain point, because debt is “less expensive” than equity. Why?

• Interest on debt is tax-deductible (hence the (1 - Tax Rate) multiplication in the WACC formula).
• Debt is senior to equity in a company’s capital structure - debt holders would be paid first in a liquidation or bankruptcy.
• Intuitively, interest rates on debt are usually lower than the Cost of Equity numbers you see (usually over 10%). As a result, the Cost of Debt portion of WACC will contribute less to the total figure than the Cost of Equity portion will.

However, the above is true only to a certain point. Once a company’s debt goes up high enough, the interest rate will rise dramatically to reflect the additional risk and so the Cost of Debt would start to increase - if it gets high enough, it might become higher than Cost of Equity and additional debt would increase WACC.
It’s a “U-shape” curve where debt decreases WACC to a point, then starts increasing it.

Question 21

Which has a greater impact on a company’s DCF valuation - a 10% change in
revenue or a 1% change in the discount rate?

Answer 21

You should start by saying, “it depends” but most of the time the 10% difference in revenue will have more of an impact. That change in revenue doesn’t affect only the current year’s revenue, but also the revenue/EBITDA far into the future and even the terminal value.

Question 22

How do you calculate WACC for a private company?

Answer 22

This is problematic because private companies don’t have market caps or Betas. In this case you would most likely just estimate WACC based on work done by auditors or valuation specialists, or based on what WACC for comparable public companies is.

Question 23

What should you do if you don’t believe management’s projections for a DCF model?

Answer 23

You can take a few different approaches:
* You can create your own projections.
* You can modify management’s projections downward to make them more
conservative.
* You can show a sensitivity table based on different growth rates and margins and show the values assuming managements’ projections and assuming a more conservative set of numbers.
In reality, you’d probably do all of these if you had unrealistic projections.

Question 24

What types of sensitivity analyses would we look at in a DCF?

Answer 24

Example sensitivities:
* Revenue Growth vs. Terminal Multiple
* EBITDA Margin vs. Terminal Multiple
* Terminal Multiple vs. Discount Rate
* Long-Term Growth Rate vs. Discount Rate
And any combination of these (except Terminal Multiple vs. Long-Term Growth Rate, which would make no sense).

This compares enterprise value with different values of these numbers

Question 25

Is interest an operating expense

Answer 25

No, it’s a non-operating expense

Question 26

Is depreciation an operating expense

Answer 26

Yes

Question 27

Does operating cash flow account for interest

Answer 27

Yes because it starts with net income

Question 28

Levered Beta =

Answer 28

Un-Levered Beta x (1 + ((1 - Tax Rate) x (Total Debt/Equity)))

Question 29

How does a increase in current liabilities affect DCF

Answer 29

Makes DCF higher, smaller NWC, subtract less

Question 30

Explain why we would use the mid-year convention in a DCF.

Answer 30

You use it to represent the fact that a company’s cash flow does not come 100% at the end of each year - instead, it comes in evenly throughout each year.
In a DCF without mid-year convention, we would use discount periods of 1 for the first year, 2 for the second year, and 3 for the third year, and so on.
With mid-year convention, we would instead use 0.5 for the first year, 1.5 for the second year, 2.5 for the third year, and so on.

Question 31

Walk me through a Dividend Discount Model (DDM) that you would use in place of a normal DCF for financial institutions.

Answer 31

The mechanics are the same as a DCF, but we use dividends rather than free cash flows:

1. Project out the company’s earnings, down to earnings per share (EPS).
2. Assume a dividend payout ratio - what percentage of the EPS actually gets paid out to shareholders in the form of dividends - based on what the firm has done historically and how much regulatory capital it needs.
3. Use this to calculate dividends over the next 5-10 years.
4. Discount each dividend to its present value based on Cost of Equity - NOT WACC - and then sums these up.
5. Calculate terminal value based on P/E and EPS in the final year, and then discount this to its present value based on Cost of Equity.
6. Sum the present value of the terminal value and the present values of the dividends to get the company’s net present per-share value.