DCF - Calcs

Question 1

What does the Cost of Equity mean intuitively?

Answer 1

It tells you the average percentage a company’s stock “should” return each year over the long
term, factoring in both stock-price appreciation and dividends.
In a valuation, it represents the average annualized return that equity investors might earn over
the long term.
To a company, the Cost of Equity represents the cost of funding its operations by issuing
additional shares to investors.
The company “pays for” Equity via potential Dividends (a real cash expense) and the dilution of
existing investors

Question 2

What does WACC mean intuitively?

Answer 2

WACC is your expected or targeted annualized return if you invest proportionately in all parts
of the company’s capital structure – Debt, Equity, and Preferred Stock.
To a company, WACC represents the cost of funding its operations by using all its sources of
capital and keeping its capital structure percentages the same over time.
Investors might invest in a company if the expected IRR exceeds its WACC, and a company
might fund a new project, acquisition, or expansion if the expected IRR exceeds its WACC.

Question 3

How do you calculate the Cost of Equity?

Answer 3

Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta
The Risk-Free Rate represents the yield on “risk-free” government bonds denominated in the
same currency as the company’s cash flows. You usually use 10-year or 20-year bonds to match
the explicit forecast period of the DCF.
Levered Beta represents the volatility of this stock relative to the market as a whole, factoring
in both intrinsic business risk and risk from leverage.
And the Equity Risk Premium represents how much the stock market in the company’s country
will return above the “risk-free” government bond yield in the long term.
Stocks are riskier and have higher potential returns than government bonds, so you take the
yield on the bonds, add the extra returns you could get from the stock market, and then adjust
for this company’s specific risk and potential returns.

Question 4

If a company operates in the EU, U.S., and U.K., what should you use for its Risk-Free Rate?

Answer 4

You should use the appropriate yield on the government bonds denominated in the currency of
the company’s cash flows.
So, if the company reports its financials in USD, you might use the yield on 10-year U.S.
Treasuries; if it reports them in EUR or GBP, you might use the yield on 10-year bonds issued by
the European Central Bank or the Bank of England.

Question 5

How do you calculate the Equity Risk Premium for a multinational company operating in
many geographies?

Answer 5

You might take the percentage of revenue earned in each country, multiply it by the ERP for
that country’s stock market, and then add the terms to get the weighted average ERP.
To calculate the ERP in each market, you would calculate the average annualized returns of the
country’s stock market vs. the Risk-Free Rate in that country over the long term. If that is not
feasible or the data does not exist, you could also take the U.S. stock market ERP and add a
default spread to represent the additional risk of the other country

Question 6

What does Beta mean intuitively?

Answer 6

Levered Beta tells you how volatile a company’s stock price is relative to the stock market as a
whole, factoring in both intrinsic business risk and risk from leverage (i.e., Debt).
If Beta is 1.0, when the market goes up 10%, this company’s stock price also increases by 10%.
If Beta is 2.0, when the market goes up 10%, this company’s stock price goes up by 20%.
If the market drops by 10%, this company’s stock price falls by 10% when the Beta is 1.0 or 20%
when the Beta is 2.0.
Unlevered Beta excludes the risk from leverage and reflects only the intrinsic business risk, so
it’s always less than or equal to Levered Beta.

Question 7

What are the formulas for un-levering and re-levering Beta, and what do they mean?

Answer 7

Unlevered Beta = Levered Beta / (1 + Debt / Equity * (1 – Tax Rate) + Preferred Stock / Equity)
Levered Beta = Unlevered Beta * (1 + Debt / Equity * (1 – Tax Rate) + Preferred Stock / Equity)
You use a “1 +” before the Debt / Equity * (1 – Tax Rate) term to ensure that Unlevered Beta is
always less than or equal to Levered Beta.
You multiply the Debt / Equity term by (1 – Tax Rate) because the tax-deductibility of interest
reduces the risk of Debt.
When you move from Levered Beta to Unlevered Beta, you divide by the “risk from leverage”
term to remove it and reduce Beta accordingly; it’s the opposite when moving from Unlevered
to Levered Beta.
You un-lever and re-lever Beta because when you calculate WACC in a DCF, you want to isolate
the “inherent business risk” and then take that risk and add the company-specific risk from
leverage for the company you’re valuing.

Question 8

How do you calculate WACC, and why does it pair with Unlevered Free Cash Flow?

Answer 8

The formula for WACC is simple:
WACC = Cost of Equity * % Equity + Cost of Debt * (1 – Tax Rate) * % Debt + Cost of Preferred
Stock * % Preferred Stock
There is some disagreement around the different ways to calculate each component, but the
basic formula is straightforward.
It pairs with UFCF because they both represent all the investors in the company. It is not
“capital structure-neutral” because no Discount Rate can be. Each investor group affects the
others!

Question 9

Why is Equity more expensive than Debt?

Answer 9

Because it offers higher risk and higher potential returns and lacks the tax benefits of Debt.
Expected stock market returns usually exceed the Yield to Maturity on Debt, making the Equity
cost higher. The interest on Debt is also tax-deductible, further reducing the Debt cost and
making Equity even more expensive.
In developed markets, the average annualized stock market return is often in the 7 – 10%
range, so a company with a Levered Beta of 1.0 will have a Cost of Equity in that range.
For the Cost of Debt to be higher, the Pre-Tax Cost would have to be ~9 – 13% at a 25% tax rate.
More speculative companies might pay interest rates in that range, but larger/mature
companies tend to pay less than that.

Question 10

How do you determine the Cost of Debt and Cost of Preferred Stock in the WACC
calculation, and what do they mean?

Answer 10

These Costs represent what the company would pay if it issued additional Debt or Preferred
Stock.
To an outside investor, these Costs represent their expected annualized returns if they held the
Debt or Preferred Stock through their maturities.
You can estimate the Cost of Debt by calculating the Yield to Maturity (YTM), which reflects the
coupon rates on the company’s bonds and their market values (e.g., a bond with a coupon rate
of 5% that’s trading at a discount to par value will have a YTM higher than 5%).
If you can’t find this information, you could also use a simple weighted average interest rate for
the issuances or take the Risk-Free Rate and add a default spread based on the company’s
expected credit rating.
The Cost of Preferred Stock is similar, but Preferred Dividends are not tax-deductible, so you do
not multiply by the (1 – Tax Rate) term in the WACC calculation.