Page | 1
Discounted Cash Flow Questions with
Detailed Verified Answers
Question: What's the basic concept behind a Discounted Cash Flow analysis?
Answer:
✓ The concept is that you value a company based on the present value of
its Free Cash Flows far into the future.
✓
✓ You divide the future into a "near future" period of 5-10 years and then
calculate, project, discount, and add up those Free Cash Flows; and
then there's also a "far future" period for everything beyond that, which
you can't estimate as precisely, but which you can approximate using
different approaches.
✓
✓ You need to discount everything back to its present value because
money today is worth more than money tomorrow.
Question: Walk me through a DCF.
Answer:
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✓ "A DCF values a company based on the Present Value of its Cash Flows
and the Present Value of its Terminal Value.
✓
✓ First, you project a company's financials using assumptions for revenue
growth, margins, and the Change in Operating Assets and Liabilities;
then you calculate Free Cash Flow for each year, which you discount
and sum up to get to the Net Present Value. The Discount Rate is
usually the Weighted Average Cost of Capital.
✓
✓ Once you have the present value of the Free Cash Flows, you determine
the company's Terminal Value, using either the Multiples Method or
the Gordon Growth Method, and then you discount that back to its Net
Present Value using the Discount Rate.
✓ Finally, you add the two together to determine the company's
Enterprise Value."
Question: Walk me through how you get from Revenue to Free Cash Flow in
the projections.
Answer:
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✓ First, confirm that they are asking for Unlevered Free Cash Flow (Free
Cash Flow to Firm). If so:
✓
✓ Subtract COGS and Operating Expenses from Revenue to get to
Operating Income (EBIT) - or just use the EBIT margin you've assumed.
✓
✓ Then, multiply by (1 - Tax Rate), add back Depreciation, Amortization,
and other non-cash charges, and factor in the Change in Operating
Assets and Liabilities. If Assets increase by more than Liabilities, this is
a negative; otherwise it's positive.
✓ Finally, subtract Capital Expenditures to calculate Unlevered Free Cash
Flow.
✓
✓ Levered Free Cash Flow (FCFE) is similar, but you must also subtract
the Net Interest Expense before multiplying by (1 - Tax Rate), and you
must also subtract Mandatory Debt Repayments at the end.
Question: What's the point of Free Cash Flow, anyway? What are you trying to
do?
Answer:
, Page | 4
✓ The idea is that you're replicating the Cash Flow Statement, but only
including recurring, predictable items. And in the case of Unlevered
Free Cash Flow, you also exclude the impact of Debt entirely.
✓
✓ That's why everything in Cash Flow from Investing except for CapEx is
excluded, and why the entire Cash Flow from Financing section is
excluded (the only exception being Mandatory Debt Repayments for
Levered FCF).
Question: Why do you use 5 or 10 years for the "near future" DCF projections?
Answer:
✓ That's about as far as you can reasonably predict for most companies.
Less than 5 years would be too short to be useful, and more than 10
years is too difficult to project for most companies.
Question: Is there a valid reason why we might sometimes project 10 years or
more anyway?
Answer:
✓ You might sometimes do this if it's a cyclical industry, such as
chemicals, because it may be important to show the entire cycle from
low to high.
Question: What do you usually use for the Discount Rate?
Answer:
Discounted Cash Flow Questions with
Detailed Verified Answers
Question: What's the basic concept behind a Discounted Cash Flow analysis?
Answer:
✓ The concept is that you value a company based on the present value of
its Free Cash Flows far into the future.
✓
✓ You divide the future into a "near future" period of 5-10 years and then
calculate, project, discount, and add up those Free Cash Flows; and
then there's also a "far future" period for everything beyond that, which
you can't estimate as precisely, but which you can approximate using
different approaches.
✓
✓ You need to discount everything back to its present value because
money today is worth more than money tomorrow.
Question: Walk me through a DCF.
Answer:
, Page | 2
✓ "A DCF values a company based on the Present Value of its Cash Flows
and the Present Value of its Terminal Value.
✓
✓ First, you project a company's financials using assumptions for revenue
growth, margins, and the Change in Operating Assets and Liabilities;
then you calculate Free Cash Flow for each year, which you discount
and sum up to get to the Net Present Value. The Discount Rate is
usually the Weighted Average Cost of Capital.
✓
✓ Once you have the present value of the Free Cash Flows, you determine
the company's Terminal Value, using either the Multiples Method or
the Gordon Growth Method, and then you discount that back to its Net
Present Value using the Discount Rate.
✓ Finally, you add the two together to determine the company's
Enterprise Value."
Question: Walk me through how you get from Revenue to Free Cash Flow in
the projections.
Answer:
, Page | 3
✓ First, confirm that they are asking for Unlevered Free Cash Flow (Free
Cash Flow to Firm). If so:
✓
✓ Subtract COGS and Operating Expenses from Revenue to get to
Operating Income (EBIT) - or just use the EBIT margin you've assumed.
✓
✓ Then, multiply by (1 - Tax Rate), add back Depreciation, Amortization,
and other non-cash charges, and factor in the Change in Operating
Assets and Liabilities. If Assets increase by more than Liabilities, this is
a negative; otherwise it's positive.
✓ Finally, subtract Capital Expenditures to calculate Unlevered Free Cash
Flow.
✓
✓ Levered Free Cash Flow (FCFE) is similar, but you must also subtract
the Net Interest Expense before multiplying by (1 - Tax Rate), and you
must also subtract Mandatory Debt Repayments at the end.
Question: What's the point of Free Cash Flow, anyway? What are you trying to
do?
Answer:
, Page | 4
✓ The idea is that you're replicating the Cash Flow Statement, but only
including recurring, predictable items. And in the case of Unlevered
Free Cash Flow, you also exclude the impact of Debt entirely.
✓
✓ That's why everything in Cash Flow from Investing except for CapEx is
excluded, and why the entire Cash Flow from Financing section is
excluded (the only exception being Mandatory Debt Repayments for
Levered FCF).
Question: Why do you use 5 or 10 years for the "near future" DCF projections?
Answer:
✓ That's about as far as you can reasonably predict for most companies.
Less than 5 years would be too short to be useful, and more than 10
years is too difficult to project for most companies.
Question: Is there a valid reason why we might sometimes project 10 years or
more anyway?
Answer:
✓ You might sometimes do this if it's a cyclical industry, such as
chemicals, because it may be important to show the entire cycle from
low to high.
Question: What do you usually use for the Discount Rate?
Answer:
