Impact Of Changes On A DCF And WACC

Question 1

You’re looking at two companies, both of which produce identical total Free Cash Flows over a 5-year period. Company A generates 90% of its Free Cash Flow in the first year and 10% over the remaining 4 years. Company B generates the same amount of Free Cash Flow in each year.
Which one has the higher net present value?

Answer 1

A, as money today is worth more than money tomorrow.

Generating higher cash flow earlier on will boost a company’s value in a DCF

Question 2

Should Cost of Equity be higher for a $5 billion or $500 million Market Cap company?

Answer 2

500, as smaller companies are expected to outperform large companies in the stock market, riskier.

Question 3

What about WACC – will it be higher for a $5 billion or $500 million company?

Answer 3

Depends on whether or not capital structure is the same for both companies.
- if capital structure is the same, WACC should be higher for 500 million company.
- if not same, depends on how much debt/ preferred stock each one has and what the interest rates are.

Question 4

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

Answer 4

Higher debt makes company more riskier, which increases Levered Beta, increasing Cost of Equity.

Question 5

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

Answer 5

Without debt = higher WACC, as debt is less expensive than equity
- interest on debt is tax-deductible, hence the (1-tax rate) multiplication in the WACC formula
- debt is senior to equity in capital structure
- interest rates on debt are usually than CoE, so cost of debt portion of WACC will contribute less to the total figure than CoE portion.

Question 6

so are you saying that a company that does not take on Debt is at a disadvantage to one that does? How does that make sense?

Answer 6

The one without debt wont be valued as much because the way the WACC formula works.

• keep in mind, companies dont make big decisions based financial formulas.

Question 7

Let’s say that we assume 10% revenue growth and a 10% Discount Rate in a DCF analysis. Which change will have a bigger impact: reducing revenue growth to 9%, or reducing the Discount Rate to 9%?

Answer 7

Discount rate as it affects everything from the PV of FCF to the PV of the TV.

Question 8

What about if we change revenue growth to 1%? Would that have a bigger impact, or would changing the Discount Rate to 9% have a bigger impact?

Answer 8

In this case, the change in revenue growth is likely to have a bigger impact because you’ve changed it by 90%, only changed the DR by 10%.

Lower revenue growth will push down the present value of the TV as well as the present value of the FCF

Question 9

The Free Cash Flows in the projection period of a DCF analysis increase by 10% each year. How much will the company’s Enterprise Value increase by?

Answer 9

A % less than 10%, for two reasons:
1. Remember we discount all those FCFs, so even if they increase by 10%, present value change is less than 10%
2. There’s still the TV and the Present value of that, that hasn’t increased by 10%, so neither has the company’s total value

Question 10

Let’s say that we want to analyze all these factors in a DCF. What are the most common sensitivity analyses to use?

Answer 10

Common sensitivities:
- revenue growth vs terminal multiple
- EBITDA Margin vs Terminal multiple
- terminal multiple vs discount rate
- terminal growth rate vs discount rate

Question 11

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 11

Don’t account for this at all in Unlevered DCF, as you ignore interest expense and debt principal repayments.

In levered DCF, factor in by reducing interest expense each year as debt falls, and reduce FCF by mandatory repayments each year.

Exact impact - whether the implied EV goes up or down - depends on the interest rate and the principal repayment % each year, usually principal repayments far exceed the net interest expense, so EV will most likely decrease because Levered FCF will be lower each year.

Question 12

So if you’re using Levered FCF to value a company, is the company better off paying off Debt quickly or repaying the bare minimum required?

Answer 12

Always better to pay the bare minimum as lets say:
- interest rates on debt rarely fo above 10%, company has 1000 in debt
- initially pays 100 in interest expense, and after taxes that’s 60, so levered FCF is reduced by 60 each year assuming no principal repayment
- if company decides to repay 200 of that debt each year, levered FCF down at least 200 each year
So valuation wise, company is better off waiting as long as possible to repay debt.