Discounted Cash Flow Practice Test Questions and Correct Answers
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Discounted Cash Flow
Institution
Discounted Cash Flow
Walk me through a DCF - DCF values a company based not he PV of its Cash Flows and PV of its Terminal value
1) project out a company's financial using assumptions for revenue growth, expenses, and working capital to get FCF for each year 2) discount each year's FCF based on your discount rate - us...
Discounted Cash Flow Practice Test
Questions and Correct Answers
Walk me through a DCF ✅- DCF values a company based not he PV of its Cash Flows
and PV of its Terminal value
1) project out a company's financial using assumptions for revenue growth, expenses,
and working capital to get FCF for each year
2) discount each year's FCF based on your discount rate - usually WACC
3) after getting the FCFs, determine terminal value by using the Multiples Method or
Gordon Growth Method and then also discount this to Net Present Value using WACC
4) To get Enterprise Value, you add the PV of FCFs and the PV of the Terminal Value
Walk me through how you get From Revenue to FCF in the projections ✅1) To get
Operating Income (EBIT), you subtract COGS and Operating Expenses from Revenue
2) then multiply Operating Income (EBIT) by (1-Tax Rate)
3) add back Depreciation and other non-cash charges
4) subtract Capital Expenditures and the change in Working Capital
This gets you unlettered Free Cash Flow (since you started with EBIT not EBT)
What's an alternative way to calculate FCF aside from taking NI + Depreciation -
Changes in Operating Assets/Liabs and Capex? ✅You can also take Cash Flow from
Operations and subtract CapEx to get Levered Cash Flow
To get Unlevered Cash Flow, you need to
1) add back the tax-adjusted interest expense
2) subtract tax-adjusted Interest Income
Why do you use 5 or 10 years for DCF projections? ✅that's usually how far into the
future one can reasonably predict
less than 5 years is too short 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 though you
may also look at using the Cost of Equity depending on how you've set up the DCF
How do you calculate WACC? ✅WACC
= Cost of Equity (% Equity)
+ Cost of Debt (% Debt ) (1-Tax Rate)
+ Cost of Preferred (% Preferred)
, For Cost of Equity, you can use CAPM (capital asset pricing model) and for others, you
can look at comparable companies/debt issuances and the interest rates and yields
issued by similar companies
Hod do you calculate Cost of Equity? ✅Cost of Equity = risk free rate + Beta(equity
risk premium)
- Risk free rate represents how much a 10yr or 20yr UST should yield
- Beta is calculated based on the "riskiness" of the Comparable Companies
- Equity Risk Premium is the % by which stocks are expected to out-perform "rissoles"
assets (normally can pull this from Ibbotson's)
you can also add in a SIZE premium or INDUSTRY premium to account for how much a
company is expected to out-perform it's peers according to its market cap or industry
e.g. small company stocks are expected to out-perform large company stocks
How do you get Beta in the Cost of Equity calc? ✅1) Using Bloomberg, you can look
up the Beta for each Comparable Company
2) unloved each of the betas, and then lever it based on your company's capital
structure
3) use the new Levered Beta int he cost of Equity calculations
Why do you have to lever and unlever Beta? ✅we want to have an "apples to apples"
approach to our analysis
- when you look at Betas for comparable firms, they will be levered to reflect the debt
already assumed by each firm
- BUT each company's capital structure is different and we want to look at how "risky" a
company is regardless of the % of debt it has so we must un-lever Beta
- we need to re-lever Beta for our Cost of Equity calculation because we want it to
reflect the true risk to our company, taking into account its' unique capital structure
Would you expect a manufacturing company or a tech company to have a higher Beta?
✅tech company - viewed as "riskier" than manufacturing
What is the effect of using Levered FCF rather than Unlevered FCF in your DCF?
✅Levered FCF gives you Equity Value, not Enterprise Value (since the CF is only avail
to Equity Investors - debt investors have been paid with the interest)
If you use Levered Cash Flow, what should use as the Discount Rate? ✅Cost of
Equity (since Levered Cash Flow represents the Equity Value)
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