Discounted Cash Flow Questions &
Answers | updated
Walk me through a DCF.
"A DCF values a company based on the Present Value of its Cash Flows and the
Present Value of its Terminal Value.
First, you project out a company's financials using assumptions for revenue growth,
expenses and Worki...
Discounted Cash Flow Questions &
Answers | updated
Walk me through a DCF.
"A DCF values a company based on the Present Value of its Cash Flows and the
Present Value of its Terminal Value.
First, you project out a company's financials using assumptions for revenue growth,
expenses and Working Capital; then you get down to Free Cash Flow for each year,
which you then sum up and discount to a Net Present Value, based on your discount
rate - usually the Weighted Average Cost of Capital.
Once you have the present value of the Cash Flows, you determine the company's
Terminal Value, using either the Multiples Method or the Gordon Growth Method, and
then also discount that back to its Net Present Value using WACC.
Finally, you add the two together to determine the company's Enterprise Value."
Walk me through how you get from Revenue to Free Cash Flow in the projections.
Subtract COGS and Operating Expenses to get to Operating Income (EBIT). Then,
multiply by (1 - Tax Rate), add back Depreciation and other non-cash charges, and
subtract Capital Expenditures and the change in Working Capital.
Note: This gets you to Unlevered Free Cash Flow since you went off EBIT rather than
EBT. You should confirm that this is what the interviewer is asking for.
Brainpower
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?
Take Cash Flow From Operations and subtract CapEx and mandatory debt repayments
- 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.
We have an expert-written solution to this problem!
Why do you use 5 or 10 years for DCF projections?
That's usually about as far as you can reasonably predict into the future. Less than 5
years would be too short to be useful, and over 10 years is too difficult to predict for
most companies.
What do you usually use for the discount rate?
Normally you use WACC (Weighted Average Cost of Capital), though you might also
use Cost of Equity depending on how you've set up the DCF.
How do you calculate WACC?
, The formula is: Cost of Equity (% Equity) + Cost of Debt (% Debt) (1 - Tax Rate) +
Cost of Preferred (% Preferred).
In all cases, the percentages refer to how much of the company's capital structure is
taken up by each component.
For Cost of Equity, you can use the Capital Asset Pricing Model (CAPM - see the next
question) and for the others you usually look at comparable companies/debt issuances
and the interest rates and yields issued by similar companies to get estimates.
How do you calculate the Cost of Equity?
Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium
The risk-free rate represents how much a 10-year or 20-year US Treasury should yield;
Beta is calculated based on the "riskiness" of Comparable Companies and the Equity
Risk Premium is the % by which stocks are expected to out-perform "risk-less" assets.
Normally you pull the Equity Risk Premium from a publication called Ibbotson's.
Note: This formula does not tell the whole story. Depending on the bank and how
precise you want to be, you could also add in a "size premium" and "industry premium"
to account for how much a company is expected to out-perform its peers is according to
its market cap or industry.
Small company stocks are expected to out-perform large company stocks and certain
industries are expected to out-perform others, and these premiums reflect these
expectations.
How do you get to Beta in the Cost of Equity calculation?
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:
Levered Beta = Un-Levered Beta x (1 + ((1 - Tax Rate) x (Total Debt/Equity)))
Why do you have to un-lever and re-lever Beta?
Again, keep in mind our "apples-to-apples" theme. When you look up the Betas on
Bloomberg (or from whatever source you're using) they will be levered to reflect the debt
already assumed by each company.
But each company's capital structure is different and we want to look at how "risky" a
company is regardless of what % debt or equity it has.
To get that, we need to un-lever Beta each time.
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