400 IB: Discounted Cash Flow Questions
& Answers - Basic
1. Walk me thru a DCF. - ANS-"A DCF values a business enterprise based at the Present Value
of its Cash Flows and the Present Value of its Terminal Value.
First, you project out a organisation's financials using assumptions for revenue growth,
expenses and Working Capital; then you get all the way down to Free Cash Flow for each yr,
that you then sum up and bargain to a Net Present Value, based in your cut price fee - normally
the Weighted Average Cost of Capital.
Once you have got the prevailing fee of the Cash Flows, you decide the enterprise's Terminal
Value, the usage of both the Multiples Method or the Gordon Growth Method, after which
additionally cut price that lower back to its Net Present Value using WACC.
Finally, you add the two collectively to determine the company's Enterprise Value."
A business enterprise has a high debt load and is paying off a tremendous part of its main each
yr. How do you account for this in a DCF? - ANS-Trick question. You don't account for this in
any respect in a DCF, because paying off debt predominant suggests up in Cash Flow from
Financing at the Cash Flow Statement - however we handiest cross all the way down to Cash
Flow from Operations after which subtract Capital Expenditures to get to Free Cash Flow.
If we have been looking at Levered Free Cash Flow, then our hobby cost might decline in future
years due to the predominant being paid off - but we still wouldn't count the foremost payments
themselves everywhere.
Cost of Equity tells us what form of go back an equity investor can assume for making an
investment in a given corporation - but what approximately dividends? Shouldn't we component
dividend yield into the components? - ANS-Trick question. Dividend yields are already factored
into Beta, because Beta describes returns in extra of the marketplace as an entire - and people
returns consist of dividends.
How can we calculate Cost of Equity WITHOUT the usage of CAPM? - ANS-There is an change
components:Cost of Equity = (Dividends in keeping with Share / Share Price) + Growth Rate of
Dividends
This is less commonplace than the "fashionable" formulation however on occasion you use it for
organizations where dividends are extra important or whilst you lack proper facts on Beta and
the opposite variables that cross into calculating Cost of Equity with CAPM.
How do you calculate the Cost of Equity? - ANS-Cost of Equity = Risk-Free Rate + Beta * Equity
Risk Premium
The threat-unfastened price represents how a whole lot a ten-year or 20-year US Treasury
ought to yield; Beta is calculated based on the "riskiness" of Comparable Companies and the
, Equity Risk Premium is the % through which stocks are expected to out-perform "danger-much
less" belongings.
Normally you pull the Equity Risk Premium from a e-book referred to as Ibbotson's. Note: This
method does no longer inform the whole tale. Depending at the bank and the way
precise you want to be, you may also add in a "size top rate" and "enterprise top class" to
account for the way a great deal a business enterprise is anticipated to out-carry out its friends
is in step with its marketplace cap or enterprise.
Small agency stocks are predicted to out-carry out massive enterprise shares and sure
industries are predicted to out-perform others, and those premiums mirror those expectations.
How do you calculate the Terminal Value? - ANS-You can either apply an exit a couple of to the
agency's Year 5 EBITDA, EBIT or Free Cash Flow (Multiples Method) or you could use the
Gordon Growth technique to estimate its value based on its increase fee into perpetuity.
The formula for Terminal Value using Gordon Growth is: Terminal Value = Year 5 Free Cash
Flow * (1 + Growth Rate) / (Discount Rate - Growth Rate).
How do you calculate WACC for a private business enterprise? - ANS-This is complicated due
to the fact personal corporations don't have marketplace caps or Betas. In this situation you will
maximum likely just estimate WACC based totally on paintings carried out with the aid of
auditors or valuation professionals, or based on what WACC for similar public agencies is.
How do you calculate WACC? - ANS-The formulation is: Cost of Equity * (% Equity) + Cost of
Debt * (% Debt) * (1 - Tax Rate) + Cost of Preferred * (% Preferred).
In all cases, the odds refer to how lots of the organization's capital shape is taken up by using
each issue.
For Cost of Equity, you may use the Capital Asset Pricing Model (CAPM - see the subsequent
question) and for the others you typically have a look at similar businesses/debt issuances and
the interest fees and yields issued with the aid of comparable businesses to get estimates.
How do you get to Beta inside the Cost of Equity calculation? - ANS-You appearance up the
Beta for every Comparable Company (typically on Bloomberg), un-lever each one, take the
median of the set after which lever it based totally for your organization's capital shape. Then
you operate this Levered Beta within the Cost of Equity calculation.
For your reference, the formulas for un-levering and re-levering Beta are under:
Un-Levered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Total Debt/Equity))) Levered Beta =
Un-Levered Beta x (1 + ((1 - Tax Rate) x (Total Debt/Equity)))
How do in case your DCF is too dependent on future assumptions? - ANS-The "fashionable"
answer: if significantly greater than 50% of the business enterprise's Enterprise Value comes
from its Terminal Value, your DCF is probably too dependent on future assumptions.
In truth, almost all DCFs are "too dependent on future assumptions" - it's really pretty
uncommon to peer a case in which the Terminal Value is much less than 50% of the Enterprise
Value.
But when it receives to be inside the eighty-90% range, that you can want to re-think your
assumptions...
How do you select the perfect exit multiple whilst calculating Terminal Value? - ANS-Normally
you have a look at the Comparable Companies and pick the median of the set, or some thing
close to it.
& Answers - Basic
1. Walk me thru a DCF. - ANS-"A DCF values a business enterprise based at the Present Value
of its Cash Flows and the Present Value of its Terminal Value.
First, you project out a organisation's financials using assumptions for revenue growth,
expenses and Working Capital; then you get all the way down to Free Cash Flow for each yr,
that you then sum up and bargain to a Net Present Value, based in your cut price fee - normally
the Weighted Average Cost of Capital.
Once you have got the prevailing fee of the Cash Flows, you decide the enterprise's Terminal
Value, the usage of both the Multiples Method or the Gordon Growth Method, after which
additionally cut price that lower back to its Net Present Value using WACC.
Finally, you add the two collectively to determine the company's Enterprise Value."
A business enterprise has a high debt load and is paying off a tremendous part of its main each
yr. How do you account for this in a DCF? - ANS-Trick question. You don't account for this in
any respect in a DCF, because paying off debt predominant suggests up in Cash Flow from
Financing at the Cash Flow Statement - however we handiest cross all the way down to Cash
Flow from Operations after which subtract Capital Expenditures to get to Free Cash Flow.
If we have been looking at Levered Free Cash Flow, then our hobby cost might decline in future
years due to the predominant being paid off - but we still wouldn't count the foremost payments
themselves everywhere.
Cost of Equity tells us what form of go back an equity investor can assume for making an
investment in a given corporation - but what approximately dividends? Shouldn't we component
dividend yield into the components? - ANS-Trick question. Dividend yields are already factored
into Beta, because Beta describes returns in extra of the marketplace as an entire - and people
returns consist of dividends.
How can we calculate Cost of Equity WITHOUT the usage of CAPM? - ANS-There is an change
components:Cost of Equity = (Dividends in keeping with Share / Share Price) + Growth Rate of
Dividends
This is less commonplace than the "fashionable" formulation however on occasion you use it for
organizations where dividends are extra important or whilst you lack proper facts on Beta and
the opposite variables that cross into calculating Cost of Equity with CAPM.
How do you calculate the Cost of Equity? - ANS-Cost of Equity = Risk-Free Rate + Beta * Equity
Risk Premium
The threat-unfastened price represents how a whole lot a ten-year or 20-year US Treasury
ought to yield; Beta is calculated based on the "riskiness" of Comparable Companies and the
, Equity Risk Premium is the % through which stocks are expected to out-perform "danger-much
less" belongings.
Normally you pull the Equity Risk Premium from a e-book referred to as Ibbotson's. Note: This
method does no longer inform the whole tale. Depending at the bank and the way
precise you want to be, you may also add in a "size top rate" and "enterprise top class" to
account for the way a great deal a business enterprise is anticipated to out-carry out its friends
is in step with its marketplace cap or enterprise.
Small agency stocks are predicted to out-carry out massive enterprise shares and sure
industries are predicted to out-perform others, and those premiums mirror those expectations.
How do you calculate the Terminal Value? - ANS-You can either apply an exit a couple of to the
agency's Year 5 EBITDA, EBIT or Free Cash Flow (Multiples Method) or you could use the
Gordon Growth technique to estimate its value based on its increase fee into perpetuity.
The formula for Terminal Value using Gordon Growth is: Terminal Value = Year 5 Free Cash
Flow * (1 + Growth Rate) / (Discount Rate - Growth Rate).
How do you calculate WACC for a private business enterprise? - ANS-This is complicated due
to the fact personal corporations don't have marketplace caps or Betas. In this situation you will
maximum likely just estimate WACC based totally on paintings carried out with the aid of
auditors or valuation professionals, or based on what WACC for similar public agencies is.
How do you calculate WACC? - ANS-The formulation is: Cost of Equity * (% Equity) + Cost of
Debt * (% Debt) * (1 - Tax Rate) + Cost of Preferred * (% Preferred).
In all cases, the odds refer to how lots of the organization's capital shape is taken up by using
each issue.
For Cost of Equity, you may use the Capital Asset Pricing Model (CAPM - see the subsequent
question) and for the others you typically have a look at similar businesses/debt issuances and
the interest fees and yields issued with the aid of comparable businesses to get estimates.
How do you get to Beta inside the Cost of Equity calculation? - ANS-You appearance up the
Beta for every Comparable Company (typically on Bloomberg), un-lever each one, take the
median of the set after which lever it based totally for your organization's capital shape. Then
you operate this Levered Beta within the Cost of Equity calculation.
For your reference, the formulas for un-levering and re-levering Beta are under:
Un-Levered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Total Debt/Equity))) Levered Beta =
Un-Levered Beta x (1 + ((1 - Tax Rate) x (Total Debt/Equity)))
How do in case your DCF is too dependent on future assumptions? - ANS-The "fashionable"
answer: if significantly greater than 50% of the business enterprise's Enterprise Value comes
from its Terminal Value, your DCF is probably too dependent on future assumptions.
In truth, almost all DCFs are "too dependent on future assumptions" - it's really pretty
uncommon to peer a case in which the Terminal Value is much less than 50% of the Enterprise
Value.
But when it receives to be inside the eighty-90% range, that you can want to re-think your
assumptions...
How do you select the perfect exit multiple whilst calculating Terminal Value? - ANS-Normally
you have a look at the Comparable Companies and pick the median of the set, or some thing
close to it.
