DCF

Question 1

What is a DCF

Answer 1

• Present Value of the expect cash flows of an asset over time.
• Reflects riskiness of the CFs

Cash flows = Operating Cash flows - cash reinvestments

Question 2

Value of a company that CFs growing (perpetuity formula)

Answer 2

CF/discount rate - growth rate

do for each year and add

Question 3

Strengths of a DCF

Answer 3

1) intrinsic method not heavily dependent on external market conditions.
2) Good for companies with stable and predictable cash flows.

Question 4

Weaknesses of a DCF

Answer 4

1) Highly sensitive to assumptions (growth rates, discount rates, terminal multis)

2) Easily manipulated to produce wide range of values

Question 5

When should you not use a DCF

Answer 5

1) Unpredictable cash flows
2) Banks/financials: debt acts differently, working capital is central, interest is a core “revenue” item.

Question 6

What is terminal value

Answer 6

Estimated value of a company beyond the final year of the explicit forecast period in a DCF model.

Question 7

What is step 1 in building a DCF. What must you do

Answer 7

Project Unlevered Free Cash Flows. Project the following:

Revenue
COGS
Taxes (based on EBIT, not pre-income tax)
D&A / Non-Cash Adj
Changes in working capital
CapEx

Question 8

Why do we ignore large chunks of a company’s income statement or CFS when projecting unlevered free cash flows?

Answer 8

Ignore items like:
- Net interest exp
- Other income/(expense)

Because they are non-recurring or relate only to a specific investor group.

Question 9

What do unlevered free cash flows show us. How do you calculate it?

Answer 9

CF to firm before impact of leverage forecasted for a 5-10 year period typically.

EBIT x (1-Tax Rate) + D&A - Changes in NWC - CapEx

NOPAT + D&A - Changesin NWC - CapEx

NOPAT = EBIT * (1- Tax Rate)

Question 10

What are levered free cash flows. How do you calculate it

Answer 10

1) Cash flows that remain after payments to lenders since interest and debt paydown are deducted.
2) CF that belong to equity owners

CFO - CapEx - Debt Principal Payment

Question 11

(Step 1) How do you project the Unlevered Free Cash Flow Items. Step by step.

Answer 11

1) Project Revenue:
- % of growth rate OR
- Units sold * average selling price
- Market Share * Market Size

2) Assume an Operating (EBIT) or Project COGS and OpEx.
- Make EBIT a % of revenue

3) Calculate NOPAT (EBIT * Tax) (TAXES)
- Use company’s effective tax rate (% in line with historical rates)
- Should not reflect the tax benefits of debt since unlevered.

4) Project D&A / Other Non-Cash Adj
- D&A = % of revenue and use historical. Look at CapEx as trend (decrease/increase)
- Def Inc Tax = % of IS tax, should decrease over time

5) Project Changes in Working Capital:
- If you have 3-statement projection, link to that OR
- % Change in Rev or % or Rev

6) Project CapEx:
- Must be linked to company’s sales growth
- % of revenue since reflects maintence & growth spending.
- MUST stay ahead of D&A (% wise)

7) Calculate Unlevered FCF:
= NOPAT + D&A - Changes in NWC - CapEx

Question 12

What is step 2 in building a DCF

Answer 12

• Once you have projected UFCF

1) Discount at appropriate discount rate.

Question 13

In step 2 when you are discounting for DCF. What are the three items you discount.

Answer 13

Since companies have multiple sources of capital, will have multiple r’s, and each part of the CapStructure has different rates.

1) Cost of Equity:
- “Opportunity Cost” for just company’s common stock.

2) Cost of Debt:
- Company’s outstanding debt.
- What investors could earn from interest
- and changes in market value of debt.

3) Cost of PrefStock:
- Similar to Cost of Debt.
- PrefStock typically have higher coupons and are not tax deductible.

Question 14

How do you determine the overall discount rate for a company?

step 2

Answer 14

WACC.

Always pairs with unlevered FCF because both represent all providers of capital.

Question 15

What does Cost of Debt and Cost of Preferred Stock represent?

• How do you determine what those rates will be (2 ways)

step 2

Answer 15

Minimum Rate of Return debt holders require to take on burden of providing debt to finance certain borrower

1) YTM on bond/debt
- Best reflects current market, find on bloomburg.

2)
Pre-Tax Cost of Debt =
Annual Interest rate / Total Debt

Post = Pre-Tax * (1-Tad Rate

Question 16

What is the cost of equity / how do we calculate it

step 2

Answer 16

Expected rate of return equity investors require to compensate for risk.

Use CAPM

Question 17

What is CAPM and how do you calculate it

step 2

Answer 17

Capital Asset Pricing Model

Ke = Risk-Free-Rate + Equity Risk Premium * levered Beta

Question 18

What is Risk Free Rate and how do you calculate it

step 2

Answer 18

Return we should get for zero risk. Source of this is US 10yr treasury

(idea that US will never default on debt)

Question 19

What is leveraged Beta

step 2

Answer 19

• How much risk we are taking by investing in a company/how volatile is this stock
• Factoring in both intrinsic business risk and risk from leverage.
• Allows us to take the average rate of return and see if it is more or less risky.

Question 20

How do you calculate the leverage Beta (2 ways)
step 2

Answer 20

1) Based on company’s stock price history.

2) Analysis of peer companies.

Question 21

What is Equity Risk Prem (ERP) also known as Risk Free Rate

step 2

Answer 21

• reward for taking risk (stock vs bonds)
• Relative to 10 year treasures (risk free bonds)

Question 22

What are the main points of disagreement on ERP. What range do you typically use

step 2

Answer 22

1) Do you use historical numbers or projected. (projected make more sense but how can you project stock market performance)

2) Do you use arithmetic or geometric mean

3) What period do you use? 10, 20, 50 years?

Typically use 6-8% in developed countries. Higher in emerging markets.

Question 23

Explain the process of unlvering and re-levering beta

step 2

Answer 23

Unlevered Beta = Levered B/(1+debt/equity ratio * ( 1-tax rate) + preferred/equity ratio).
- Always less than or equal to levered beta.

THEN:

Re-lever
Levered = Unlevered (1+ D/E * (1-tax) + pref/Equity)

Question 24

Why is levered beta less than or equal to unlevered beta

step 2

Answer 24

It reflects 2 risk
1) Debt
2) Inherent business risk (what unlevered beta accounts for)

Question 25

Why do we unlever a beta step 2

Answer 25

1) useful to compare different capital structures as focuses on equity risk. 2) By removing debt, we can see the risk of only companys assets

Question 26

Step 2 final: Once you calculate everything you need for WACC. What must you do to WACC

Answer 26

Go back to FCF projections and discount FCF to PV using same DR each year, then sum up.

Question 27

What is step 3 of a DCF?

Answer 27

Terminal Value: Calculate the company's value in far-future period.

Question 28

How do you calculate terminal value (2 methods) step 3

Answer 28

1) Final Forecast Year FCF * (1+terminal FCF growth rate) OVER Discount rate - Terminal FCF Growth Rate 2) Terminal EBITDA or EBIT or NOPAT * FCF multi * relevent Metric

Question 29

What range should the terminal growth rate be in developed markets step 3

Answer 29

1-3%

Question 30

step 3 Once you have calculate the terminal value what must you do next

Answer 30

Discount back to PV to calculate what the company is worth today. Do same a PV formula but with terminal value Terminal Value / (1 + r)^ Year #

Question 31

Once you have discounted the terminal value what is the final step

Answer 31

Add PV of Terminal Value + Sum of PV of FCF = Implied EV (private companies)

Question 32

If it a public company what is the final step you have to do to get its implied value

Answer 32

- Back into company's implied EQV and Implied share price 1) Move from EV to EQV (add non-core assets - L/E) 2) Implied share price: EQV/Diluted share count

Question 33

DCF Changes Effects on: Cost of Equity, Cost of Debt, WACC, Implied value from DCF)

Answer 33

Rule 1) More risk -> higher discount rate -> lower valuation Rule 2) Debt makes WACC fall at first, then rise (U shape). - So WACC decrease initally then starts to increase (U Shape) Rule 3) Taxes make debt cheaper - Higher taxes -> bigger tax shield -> WACC down

Question 34

Smaller Company (Cost of Equity, Cost of Debt, WACC, Implied value from DCF)

Answer 34

Cost of Eq = Higher (higher risk -> higher beta -> higher required return) - Higher discount rate / lower PV of CF Cost of debt = lower (usually have less debt so lower leverage) WACC = Lower (debt is cheaper than equity) Implied = Lower - Higher cost of equity - Smaller companies have lower margins, higher volatility, lower terminal growth

Question 35

why does discount rate and terminal value make one of the biggest impacts on DCF

Answer 35

- discount rate affects everything - Reduce your PV of CF - Lower PV of TV, which is over 50% of Implied value

Question 36

Impact of risk free rate

Answer 36

- Increases the cost of equity and cost of debt -> increases WACC -> lower implied value. - This is becuase, a higher RfR means investors can now earn more safe returns - As such, a risker investment must offer a higher return to make it more attractive - That higher return is WACC.

Question 37

Impact of equity risk premium

Answer 37

Higher: - Increase CoE and Higher WAAC - No effec ton debt since earn fixed interest. - Implied value down

Question 38

Why do we build a DCF to value a company

Answer 38

- Theory says company worth PV of expected Future CFs - But cash flow growth rate and discount rate change over time. - DCF lets us split this up into two periods: 1) explicit forecast period: where they change 2) Terminal: stay the same Then project CFs in both period and discount to PV based on appropriate discount rate(s). Finally compare the implied value (sum of these) to asking price/current value to see if its valued appropriately.

Question 39

Walk me through a DCF

Answer 39

- Most common approach through unlevered DCF. - Valuing a company based on the present value of its CFs in the explicit period and PV of terminal value. 1) Project Unlevered FCF - Over the next 5-10 years - Making assumptions for revenue growth, margins, WC, CapEx 2) Calculate Terminal Value: - Multiples Method - Gordon Growth method - Represents company value after those 5-10 years 3) Discount Unlevered FCF + tv - Usually WAAC and sum everything up. - Gives you implied EV 4) Get EQV: - Sub net debt and other non-equity claims (ex: minInt) - net debt: Non-Opp Assets (cash/inv) - debt. 5) Price per share: - EQV/Diluted shares outstanding @ valuation date. - For public companies can compare to current share price 6) Create a sensitivity table to see how assumptions impact implied share price.

Question 44

What is the multiples method

Question 45

what is the gordon growth model

Question 48

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