Discounted Cash Flow Practice Test Questions and Complete Solutions
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Discounted Cash Flow
Institution
Discounted Cash Flow
What are the 6 basic steps of a DCF? 1) Project the company's free cash flow over 5-10 years 2) calculate the company's discount rate - usually WACC 3) Discount and sum up the company's free cash 4) Calculate the company's terminal value 5) Discount the terminal value to the present value 6) add th...
Discounted Cash Flow Practice Test
Questions and Complete Solutions
What are the 6 basic steps of a DCF? ✅1) Project the company's free cash flow over
5-10 years
2) calculate the company's discount rate - usually WACC
3) Discount and sum up the company's free cash
4) Calculate the company's terminal value
5) Discount the terminal value to the present value
6) add the discounted free cash flows to the discounted terminal
What is the difference between leveraged and unlevered free cash flows?
✅Leveraged: includes interest expenses, interest income, and mandatory debt
repayments.
unleveraged: doesn't include those
What are two formulas for find cost of equity? ✅2 WAYS:
1) CAPM: (capital asset pricing model)
rE = rU + (rU-rd)BLev
BLev = Bunlev*(1+(1-t)(1+D/E)
rE = D1/P0 + g
For unlevered free cash flows, what discount rate should we use? ✅Wacc, because
we care about all parts of the company's capital structure and we want to find the value
to all investors
If we are using levered free cash flows, what discount rate should we use? ✅we would
use the cost of equity to find the value of the firm to the equity investors
What is WACC affected by debt, preferred stock, and equity? ✅1) increase debt,
decrease wacc: tax saving
2) increase preferred, increase wacc
3) increase equity, increase wacc
what if the company's capital structure changes in the future? ✅ideally we would use
the company's targeted or planned capital structure rather than the one they currently
have... if we have access to that information.
, (no one "knows" how a company's capital structure will change far in advance.)
How do we find the terminal value? ✅Terminal Value = Final Year Free Cash Flow * (1
+ Terminal FCF Growth Rate) / (Discount Rate - Terminal FCF Growth Rate).
Comparing smaller and bigger companies, who have a higher cost of equity?
✅Smaller companies - more risky - higher return
Compare cost of equity of firms in emerging and fast-growing geographies and markets
to those in stable markets? ✅cost of equity of firms in emerging and fast-growing
geographies and markets will be higher
What does more debt cause to cost of equity? ✅increased leverage, increases cost of
equity
What happens to cost of equity when there is additional equity? ✅Cost of equity
decreases because there is less debt - less risky
What's the basic concept behind a Discounted Cash Flow analysis? ✅The foundation
of a DCF is that we want to find the net present value of the company based on its
future free cash flows.
We need to discount everything back to the present value because money today is
worth more than money tomorrow. (TVM)
Walk me through a DCF. ✅1) Project out the company's free cash flows for 5-10 years
based on our growth rate assumptions.
We want to keep it short because our estimations will be more accurate.
Free cash flow
= EBIT (1-t) - CapEx + Dep & Amort - change in NWC
2) Find the terminal value of the company either through the terminal multiple method or
the gordon growth method.
3) Discount the free cash flow and the terminal value back to the present value by using
the discount rate - usually the wacc
PV = FCFn / (1+wacc)^n
*drawbacks of DCF
Why do we subtract capex in our formula to find free cash flow? ✅Because we incur
an expense to maintain the operations of our business
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