. What's an appropriate growth rate to use when calculating the Terminal Value? - answer-Commonly, we use the country's long term GDP growth rate or rate of inflation (usually something converservative)
. Why would you use the Gordon Growth Method rather than the Multiples Method to calculate th...
DISCOUNTED CASH FLOW EXAM AND
ANSWERS
. What's an appropriate growth rate to use when calculating the Terminal Value? -
answer-Commonly, we use the country's long term GDP growth rate or rate of
inflation (usually something converservative)
. Why would you use the Gordon Growth Method rather than the Multiples Method to
calculate the Terminal Value? - answer-There may be a few reasons why we may
want to use the gordon growth method.
1) if there are no good comparable companies
2) if the industry is cyclical, it may be better to use the long term growth rate
instead of the exit multiples
(Note: In banking, we always want to use the multiples method to find the terminal
value because it does not involve estimating the growth rate)
A company has a high debt load and is paying off a significant portion of its
principal each year. How do you account for this in a DCF? - answer-Since paying off
the principle is an financing activity, the DCF is not affected.
It would simply show up on the Cash flow statement.
An alternative to the DCF is the Dividend Discount Model (DDM). How is it different
in the general case (i.e. for a normal company, not a commercial bank or insurance
firm?) - answer-1) Project revenue and expenses for 5-10 years and find the
terminal value
2) Instead of finding FCF, we find dividends issued by assuming dividend as a
percentage of net income.
3) Discount the dividends and the terminal value back to present value using cost of
equity.
Unlike the DCF where we find the enterprise value, DDM gives us the equity value.
As an approximation, do you think it's OK to use EBITDA - Changes in Operating
Assets and Liabilities - CapEx to approximate Unlevered Free Cash Flow? - answer-
EBITDA ignores taxes all together. While it can work as a quick approximation, it
would be better to consider:
EBITDA - Changes in Operating Assets and Liabilities - CapEx - TAXES
Can Beta ever be negative? What would that mean? - answer-Yes, in theory, a
negative beta means that the company is a counter-cyclical one.
When the economy is thriving, the business is struggling and vise versa.
, Compare cost of equity of firms in emerging and fast-growing geographies and
markets to those in stable markets? - answer-cost of equity of firms in emerging
and fast-growing geographies and markets will be higher
Comparing smaller and bigger companies, who have a higher cost of equity? -
answer-Smaller companies - more risky - higher return
Cost of Equity tells us the return that an equity investor might expect for investing
in a given company - but what about dividends? Shouldn't we factor dividend yield
into the formula under CAPM? - answer-1) rE = rU + (rU-rd)BLev
BLev = Bunlev*(1+(1-t)(1+D/E)
Dividend yield is already considered in Beta. Beta describes the return in excess of
the market, which includes the dividend yield.
For unlevered free cash flows, what discount rate should we use? - answer-Wacc,
because we care about all parts of the company's capital structure and we want to
find the value to all investors
How can you check whether your assumptions for Terminal Value using the
Multiples Method vs. the Gordon Growth Method make sense? - answer-One way we
can check if our assumptions for the terminal value is to calculate the terminal
value using one method and then check what the implied long term growth rate is
with the other method.
For instance, with an
How do we find the terminal value? - answer-Terminal Value = Final Year Free Cash
Flow * (1 + Terminal FCF Growth Rate) / (Discount Rate - Terminal FCF Growth
Rate).
How do you calculate Beta in the Cost of Equity calculation? - answer-1) for a set of
public comps, we need to find the levered beta for each company. Unlever it and
find the mediam unlevered beta. Then we lever the unlevered based on the
company's captial structure.
How do you calculate WACC for a private company? - answer-Since private
companies don't have market caps or betas, we would rely on the WACC down by
auditors or estimate based on what the WACC is for similar public companies.
How do you calculate WACC? - answer-WACC = Cost of Equity * (% Equity) + Cost of
Debt * (% Debt) * (1 - Tax Rate) + Cost of Preferred * (% Preferred)
How do you determine a firm's Optimal Capital Structure? What does it mean? -
answer-To maximize the value of the firm, we need to find a combination of capital
structure that Min WACC.
This will often be when the marginal benefit of the tax saving = to the marginal cost
of bankruptcy or financial distress.
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