Discounted Cash Flow Questions and Correct Answers- Advanced
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Discounted Cash Flow
Institution
Discounted Cash Flow
Explain why we would use the mid-year convention in a DCF. You use it to represent the fact that a company's cash flow does not come 100% at the end of each year - instead, it comes in evenly throughout each year. In a DCF without mid-year convention, we would use discount period numbers of 1 for t...
Discounted Cash Flow Questions and
Correct Answers- Advanced
Explain why we would use the mid-year convention in a DCF. ✅You use it to represent
the fact that a company's cash flow does not come 100% at the end of each year -
instead, it comes in evenly throughout each year.
In a DCF without mid-year convention, we would use discount period numbers of 1 for
the first year, 2 for the second year, 3 for the third year, and so on.
With mid-year convention, we would instead use 0.5 for the first year, 1.5 for the second
year, 2.5 for the third year, and so on.
What discount period numbers would I use for the mid-year convention if I have a stub
period - e.g. Q4 of Year 1 - in my DCF? ✅The rule is that you divide the stub discount
period by 2, and then you simply subtract 0.5 from the "normal" discount periods for the
future years. Example for a Q4 stub:
Q4 Year1 Year2 Year3 Year4 Year5 Normal Discount Periods with Stub: 0.25 1.25 2.25
3.25 4.25 5.25 Mid-Year Discount Periods with Stub: 0.125 0.75 1.75 2.75 3.75 4.75
How does the terminal value calculation change when we use the mid-year convention?
✅When you're discounting the terminal value back to the present value, you use
different numbers for the discount period depending on whether you're using the
Multiples Method or Gordon Growth Method:
• Multiples Method: You add 0.5 to the final year discount number to reflect the fact that
you're assuming the company gets sold at the end of the year.
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• Gordon Growth Method: You use the final year discount number as is, because you're
assuming the cash flows grow into perpetuity and that they are still received throughout
the year rather than just at the end.
If I'm working with a public company in a DCF, how do I calculate its per-share value?
✅Once you get to Enterprise Value, ADD cash and then subtract debt, preferred stock,
and minority interest (and any other debt-like items) to get to Equity Value.
Then, you need to use a circular calculation that takes into account the basic shares
outstanding, options, warrants, convertibles, and other dilutive securities. It's circular
because the dilution from these depends on the per-share price - but the per-share
price depends on number of shares outstanding, which depends on the per-share price.
To resolve this, you need to enable iterative calculations in Excel so that it can cycle
through to find an approximate per-share price.
Walk me through a Dividend Discount Model (DDM) that you would use in place of a
normal DCF for financial institutions. ✅The mechanics are the same as a DCF, but we
use dividends rather than free cash flows:
1. Project out the company's earnings, down to earnings per share (EPS).
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