Discounted Cash Flow Valuation/Modeling Practice Questions and Correct Answers
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Discounted Cash Flow Valuation
Institution
Discounted Cash Flow Valuation
Walk me through a Discounted Cash Flow model. 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, -Project free cash flows for five to ten years. - Predict cash flow for over 5 years usi...
Discounted Cash Flow
Valuation/Modeling Practice Questions
and Correct Answers
Walk me through a Discounted Cash Flow model. ✅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,
-Project free cash flows for five to ten years.
- Predict cash flow for over 5 years using perpetuity method
-Once future cash flows have been projected, calculate the present value of those cash
flows.
-To find the present values of the cash flows (which is equal to the company's
Enterprise Value), we discount them with the WACC, as follows. CF1/ (1+WAAC)^1
-The final cash flow (CFn) in the analysis will be the sum of the terminal value
calculation and the 5 years present cash flow
How do you calculate a firm's terminal value? ✅-Terminal multiple method. Usually the
Ebitda cash flow times the ebitda multiple.
-The second method is the perpetuity growth method where you choose a modest
growth rate, usually just a bit higher than the inflation rate or GDP growth rate, and
assume that the company can grow at this rate infinitely. You then multiply the FCF
from the final year by 1 plus (the growth rate), and divide that number by (WACC) minus
the assumed growth rate.
What is WACC and how do you calculate it? ✅WACC is the acronym for Weighted
Average Cost of Capital. It is used as the discount rate in a
discounted cash flow analysis to calculate the present value of a company's cash flows
and terminal value. It reflects the overall cost of a company's raising new capital, which
is also a representation of the riskiness of investing in the company. Mathematically,
WACC is the percentage of equity in the capital structure times the cost of equity
(calculated by the Capital Assets Pricing Model) plus percentage of debt in the capital
structure times one minus the corporate tax rate times the cost of debt—current yield on
outstanding debt—plus percentage of preferred stock in the capital structure times the
cost of preferred stock if there is any preferred stock outstanding.
Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1 - Tax Rate) + Cost of
Preferred * (% Preferred).
All else equal, should the WACC be higher for a company with $100 million of market
cap or a company with $100 billion of market cap? ✅-If the capital structures are the
same, then the larger company should be less risky and therefore have a lower WACC.
-However, if the larger company has a lot of high-interest debt, it could have a higher
WACC.
, All else equal, should the cost of equity be higher for a company with $100 million of
market cap or a company with $100 billion of market cap? ✅Typically a smaller
company is more risky therefore would have a higher cost of equity
How do you calculate Free Cash Flow? ✅𝐸𝐵𝐼𝑇(1 − 𝑇) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 & 𝐴𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛
− ∆𝑁𝑊𝐶 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
Free cash flow is the cash that flows through a company in the course year once all
cash expenses have been expensed
Why do you project out free cash flows for the DCF model? ✅The reason you project
FCF for the DCF is because FCF is the amount of actual cash that could hypothetically
be paid out to debt holders and equity holders from the earnings of a company.
When would you not want to use a DCF? ✅-If you have a company that has very
unpredictable cash flows
-In this situation, you will most likely want to use a multiples or precedent transactions
analysis.
What is Net Working Capital? ✅𝑁𝑒𝑡 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡
𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
-An increase in net working capital is a use of cash.
-A decrease in net working capital is a source of cash.
Current Assets ✅-Inventory
-Accounts receivable
-Other short-term assets.
Current Liabilities ✅-Accounts payable
-Other short term liabilities.
What happens to Free Cash Flow if Net Working Capital increases? ✅-You subtract
the change in Net Working Capital when you calculate Free Cash Flow, so if Net
Working Capital increases, your Free Cash Flow decreases and vice versa.
When would a company collect cash from a customer and not show it as revenue? If it
isn't revenue, what is it? ✅-When a customer pays for a good or service to be
delivered in the future.
-Some examples would be annual magazine subscriptions, annual contracts on cell
phone service
-The revenue is not recognized until the good or service is delivered to the customer.
-Until it is delivered, it is recorded as deferred revenue (liability) on the Balance Sheet.
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