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DCF > Key Rule #5 > Flashcards

Key Rule #5 Flashcards

1
Q

What is the discount rate?

A

Represents opportunity cost for investor- what they could earn each year by investing in similar cos

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2
Q

What does a higher discount rate mean?

A

Increased risk and increased potential returns, but less valuable b/c investor has better options elsewhere

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3
Q

What does a lower discount rate mean?

A

Lower risk, lower potential returns, but more valuable b/c investor has worse options elsewhere

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4
Q

Why do multiple DR exist?

A

b/c co have many different sources of capital

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5
Q

What are the components of DR?

A

cost of equity
cost of debt
cost of preferred stock

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6
Q

What is overall DR?

A

WACC

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7
Q

What happens if an investor invests proportionately in a co’s struc?

A

WACC gives expected long term annualized return

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8
Q

What is the WACC formula?

A

cost of equity x % equity +
cost of debt x (1-tax rate) x % debt +
cost of preferred stock x % preferred stock

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9
Q

What is cost of preferred stock?

A

rate co would pay to issue issue additional preferred stock

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10
Q

How do you predict cost of preferred stock?

A

estimate by looking at co’s current PS
or calculate weighted average coupon rate on existing PS
or median coupon rate on comp public companies

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11
Q

What is cost of debt

A

The rate co pays if it issues additional debt

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12
Q

What are the 3 ways of calculating cost of debt?

A
  • estimate
  • YTM
  • risk free rate (RFR)
  • weighted average coupon rate of co’s existing
  • median coupon rate of outstanding issuances of comp public cos
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13
Q

What is the estimation way of calculating cost of debt?

A
  • estimate by looking at coupon rate of current debt
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14
Q

How do you work the YTM method of cost of debt?

A
  • find YTM on current debt OR
  • debt issued by comparable cos
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15
Q

How do you find the cost of debt with RFR (risk free rate)?

A
  • yield of 10-20 yr “safe” gov bonds in the country (RFR)
  • what’s the new credit rating after co issues extra debt?
  • what do cos of that credit rating pay above the RFR? (%) (add this to RFR to get cost of debt)
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16
Q

What is cost of equity in valuation?

A

How much the co’s stock should return each year on average over the long term, factoring appreciation and dividends

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17
Q

How do you calculate COE?

A

capital asset pricing model (CAPM)
risk free rate + equity risk premium x levered beta

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18
Q

What is equity risk premium?

A

%tage stock market will return each year on average above and beyond yield on safe gov bonds

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19
Q

What is the conflict w calculating Equity Risk Premium?

A

Which period? Historical/ projected nums?

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20
Q

What is levered beta?

A

How volatile this stock is relative to market as a whole, factoring in intrinsic biz risk and risk via leverage (debt)

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21
Q

What are the 3 ways of calculating COE?

A

1) COE w LB from comparable cos + current cap str
2) COE w LB from comparable cos + optimal cap str
3) COE w cos historic LB + current cap str

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22
Q

Why use comparable companies to get LB?

A
  • get range of COE, WACC values
  • get implied value
  • The CAPM mtd uses past performance of co to calc beta and COE-> current value instead of implied value -> this isn’t valuation
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23
Q

What is levered beta?

A
  • beta from capiq
  • has to be unlevered to get rid of the intrinsic biz risk and leverage risk
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24
Q

Unlevered beta vs Re-levered beta

A

ULB less than or equal to re-levered beta

25
Q

Unlevered beta formula

A

levered beta / (1 + d/e x (1-taxrate) + preferred/equity)

26
Q

What is re-levering beta?

A

make it reflect risk of company being valued

27
Q

What is the re-levering beta formula?

A

ULB x (1 + d/e x (1-taxrate) + preferred/equity)

28
Q

If company has no debt or preferred stock what is Unlevered beta?

A

Unlevered beta = Levered Beta

29
Q

What does it mean to unlever beta w optimal cap str?

A
  • use median cap str % of comparable company in the formula instead
30
Q

Why is there such a thing as unlever beta w optimal cap str?

A

gets closer to implied value

31
Q

What is the COE to the company?

A

cost of funding its operations by issuing additional shares

32
Q

What does WACC mean to the company?

A

cost of funding its operations by
- using all its sources of capital and
- keeping its capital str percentages the same over time.

33
Q

How does IRR relate to WACC?

A

Investors invest if IRR > WACC
company invest in prok if IRR > WACC

34
Q

What should you use for the Risk-Free Rate if government bonds in the country are NOT risk-free (e.g., Greece)?

A
  • take the risk-free rate in a country that is risk-free eg. US UK
  • then add a default spread based on the risky country’s credit rating
  • b/c country has higher risk of defaulting
35
Q

How is Equity Risk Premium calculated?

A
  • no universal method
  • Ibbotson’s
  • historical data
36
Q

How do you calc Equity Risk Premium for a multinational company that operates in many different geographies?

A

weighted average ERP = % revenue earned in each country x ERP in that market & add everything

37
Q

Could beta ever be -ve?

A

yes
- stock price must move in opp dir of entire market
- rare- revert back to +ve quickly

38
Q

What is a way of looking at re-levered beta as?

A

What the volatility of this company’s stock
price, relative to the market as a whole, should be, based on the median business risk of its peer companies and this company’s capital structure

39
Q

What does it mean to unlever beta?

A
  • remove risk from leverage and isolate the inherent biz risk
40
Q

The formulas for Beta do not factor in the interest rate on Debt. Isn’t that wrong? More expensive Debt should be riskier.

A
  • interest rates are factored in to a degree alr- debt/ equity ratio is a proxy for interest rates on debt b/c cos w higher debt/equity ratios have to pay higher interest rates
  • But risk isn’t directly proportional to interest rates- higher interest on debt will result in lower coverage ratios but can’t say- interest is 4% instead of 1% -> risk from leverage is 4x higher
41
Q

How would you estimate the Cost of Equity for a U.S.-based high-growth technology
company?

A

“The Risk-Free Rate is around 1.3% for 10-year U.S. Treasuries. A high-growth
tech company is more volatile than the market as a whole, with a likely Beta of around 1.5. So, if you assume an Equity Risk Premium of 6%, the Cost of Equity might be around 10.3%.”

42
Q

WACC reflects the company’s entire capital structure, so why do you pair it with
Unlevered FCF? WACC is not capital structure-neutral!

A

cap str neutrality is for FCF, not DR
no DR can be cap str neutral

43
Q

why is equity more expensive than debt?

A

debt is cheaper b/c
- debt investor has a prior claim if co goes bankrupt -> debt is safer than eq -> warrants lower return -> lower interest rate than expected return on equity

  • interest paid by bonds is tax deductible
  • when issue equity, dividends are paid out. Divs are corporate income and are subject to doubel taxation- (1) corporation (2) equity holder
  • debt circumvents taxation at the corporate level (tax shield on debt)
44
Q

Should you use co’s current capstr or optimal capstru to calculate WACC?

A
  • the best capstr is one that minimizes WACC.
  • but no way to calculate it b/c can’t tell in advance how costs of eq, d and p will change as cap str changes
  • rather, use median cap str percentages from comparable public cos as proxy for optimal capstr
  • why? want to capture what capstr should be, not what it is right now
  • implied value in DCF is based on expected future cash flows
45
Q

Cost of Preferred Stock vs Cost of Debt, Cost of Equity?

A
  • PS more ex than Debt but less so that E

Why?
- higher risk and potential returns than debt, lower risk and potential returns than E
- b/c coupon rates on PS > coupon rates on Debt
- PS not tax-deductible
- yields are still lower than stock market returns

46
Q

Convertible bonds in WACC?

A
  • if share price > converstion price = count bonds as equity, use higher diluted share count -> higher EqV and greater equity in WACC
  • if bonds not currently convertible = count as debt, use YTM of equivalent, non-convertible bonds to calc cost of debt
  • don’t use stated coupon rate or YTM on convertible bonds b/c lower than standard bonds
47
Q

How do cost of equity, cost of debt and WACC change as a co uses more debt?

A
  • COE, COD always increase b/c more debt increases risk of bankruptcy, which affects all investors
  • WACC intially decreases b/c debt cheaper than equity
  • WACC increases at higher levels of debt b/c risk of bankruptcy starts to outweigh cost benefits of debt

. If the company already has a very high level of Debt, WACC is likely to increase with more Debt;
at lower levels of Debt, WACC is more likely to decrease with more Debt.

48
Q

If a company previously used 20% Debt and 80% Equity, but it just paid off all its Debt,
how does that affect its WACC?

A
  • using co’s current capstr- WACC increase b/c 20% debt is low level
  • at that low level benefits of debt tend to outweight its risks, so less debt will increase WACC
  • if using targeted/ optimal/ medical capstr from comparable companies, change won’t affect WACC b/c not using current capstr
49
Q

How does WACC change with more debt in relation to how much existing debt it has?

A

. If the company already has a very high level of Debt, WACC is likely to increase with more Debt;
at lower levels of Debt, WACC is more likely to decrease with more Debt.

50
Q

Suppose you’re calculating WACC for two similarly sized companies in the same industry, but one company is in a developed market (DM), and the other is in an emerging market (EM). Will the EM company always have a higher WACC?

A
  • RFR, ERP, COD, higher for EM -> WACC higher
  • If Levered Beta is higher for EM, cap str % are similar -> WACC is higher
  • but might not be eg. if gov controls industry, Lev beta lower b/c of reduced volatility
51
Q

What is CAPM like in a small company?

A

small co stocks tend to have higher returns and large betas

52
Q

How to calc cost of debt for private company?

A
  • come up w synthetic bond rating of firm- can use debt to equity ratio
  • then calculate cost of debt
  • estiamte rating for private debt based on comparable publicly traded debt to come up w appropriate yield.
  • and add a liquidity premium to account for less liquid nature of private debt
53
Q

How do you calculate WACC?

A
  • COE- determined by CAPM
  • to estimate COD- interest rates on debt issued by comparable cso
  • to estimate COPS- look at div yields on preferred stock by comparable cos
54
Q

What factors affect a firm’s COD?

A
  • external interest rates eg. fed funds rate
  • riskiness of biz eg. cyclical biz debt (auto) more expensive than non cyclical (healthcare)
  • tax rates: as TR increase, cost of debt decreases
  • public debt market conditions: supply and demand in bond market at time of issuance- if d<s, debt cheaper
55
Q

How do external interest rates affect firm’s COD?

A

fed funds rate eg. the higher they are the cost of debt goes up

56
Q

How does riskiness of biz affect COD?

A
  • riskiness of biz eg. cyclical biz debt (auto) more expensive than non cyclical (healthcare)
57
Q

How does tax rate affect firm’s COD?

A

as TR increase, cost of debt decreases

58
Q

How does public debt market condition affect COD?

A

supply and demand in bond market at time of issuance- if d<s, debt cheaper

DCF (6 decks)

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