DCF QUESTIONS AND ANSWERS

DCF QUESTIONS AND ANSWERS

WalkjkmejkthroughjkajkDCFjk-jkanswer--
AjkDCFjkisjkajkdiscountedjkcashjkflowjkanalysis.jkAjkDCFjkvaluesjkthejkpresentjkvaluejkofjkalljkf
uturejkcashjkflowsjkandjkterminaljkvalue.jk

Firstjkyoujkprojectjkajkcompany'sjkfinancialsjkusingjkassumptionsjkforjkrevjkgrowth,jkexpens
es,jkandjkworkingjkcapital.jkThenjkyoujkworkjkdownjktojkthejkyearlyjkFCFjkwhichjkyoujksumjkupj
kandjkdiscountjktojkajkNPVjkbasedjkonjkthejkdiscountjkratejkWACC.



OncejkyoujkhavejkthejkpresentjkvaluejkofjkthejkCFsjkyoujkdeterminejkthejkcompany'sjktermina
ljkvaluejkusingjkeitherjkthejkmultiplesjkmethodjkorjkthejkGordonjkGrowthjkMethodjkthenjkdisco
untjkusingjkWACC.

FinallyjkaddjkthejktwojktogetherjktojkdeterminejkthejkEV.

WalkjkmejkhowjkyoujkgetjkfromjkRevenuejktojkFCFjkinjkthejkprojections.jk-jkanswer--
SubtractjkCOGsjkandjkOperatingjkexpensesjktojkgetjkOperatingjkincomejk(EBIT).jkThenjkmu
ltiplyjkbyjk(1-
Taxjkrate),jkaddjkbackjkdepreciationjkandjkotherjknonjkcashjkchargesjkandjksubtractjkCapexjk
andjkchangesjkinjkworkingjkcapital.jkConfirmjkinterviewerjkisjkaskingjkforjkEBITjknotjkEBT.

What'sjkanjkalternativejkwayjktojkcalculatejkFCFjkasidejkfromjktakingjkNetjkIncomejkandjkaddi
ngjkbackjkdepreciation,jkandjksubtractingjkchangesjkinjkoperatingjkassets/
liabilitiesjkandjkCapEx.jk-jkanswer--
TakejkcashjkflowjkfromjkoperationsjkandjksubtractjkCapexjkandjkmandatoryjkdebtjkpayments
jk(LFCF).jkTojkgetjkULFCFjkyoujkneedjktojkaddjkbackjkthejktaxjkadjustedjkinterestjkexpensejka

ndjksubtractjkthejktaxjkadjustedjkinterestjkincome.

Whyjkdojkyoujkusejk5jkorjk10jkyearsjkforjkDCFjkprojections.jk-jkanswer--
Youjkdojknotjkwantjktojkmakejkpredictionsjkanyjkfurtherjkintojkthejkfuture.jkLessjkthanjk5jkyearsj
kwouldjknotjkbejkuseful.



Whatjkdojkyoujkusuallyjkusejkforjkthejkdiscountjkrate.jk-jkanswer--
WACC.jkOrjk10%jkforjkstandardjkoiljkandjkgasjkevaluation.

HowjkdojkyoujkcalculatejkWACC?jk-jkanswer--Costjkofjkequityjk*jk
%jkEquityjk+jkCostjkofjkdebtjk*jk%jkdebt*(1-Taxjkrate)jk+jkCostjkofjkPreferred*(%jkPreferred).jk

ForjkcostjkofjkequityjkyoujkcanjkusejkthejkCapitaljkassetjkpricingjkmodel.jkForjkdebtjklookjkatjkco
mps.

Howjkdojkyoujkcalculatejkthejkcostjkofjkequity?jk-jkanswer--
COE=jkRiskjkFreejkRatejk+jkBeta*EquityjkRiskjkPremium

RFR=jk10jkyearjkorjk20jkyearjkyieldjk

, Betajkisjk"riskiness"jkofjkcomparablejkcompaniesjkEquityjkriskjkpremiumjkisjkthejk
%jkbyjkwhichjkstocksjkarejkexpectedjktojkout-performjkriskjklessjkassets.

Youjkmightjkalsojkaddjkajksizejkorjkindustryjkpremium.

HowjkdojkyoujkgetjktojkBetajkinjkthejkCOEjkcalculation?jk-jkanswer--
Youjklookjkupjkbetajkforjkeachjkcomparablejkcompany,jkunjkleverjkeachjkone,jkandjktakejkthejk
medianjkofjkthejkset.jkThenjkleverjkthejkunleveredjkbasedjkonjkthejkcompany'sjkcapitaljkstruct
ure.jk

Un-LeveredjkBetajk=jkLevjkBeta/(1+((1-jkTaxjkRate)X(TotaljkDebt/Equity)))

WhyjkdojkyoujkhavejktojkunjkleverjkandjkrejkleverjkBeta?jk-jkanswer--
Youjkwantjktojkkeepjkthingsjkapplesjktojkapples.jkAjkcompanyjkhasjkajkhigherjkriskjkofjkgoingjkB
Kjkwithjkhighjkdebt.jkAlljkcompaniesjkcapitaljkstructuresjkarejkdifferent.jkWejkwantjktojklookjkatj
khowjkriskyjkajkcompanyjkisjkregardlessjkofjk%jkofjkdebtjkorjkequity.jk



YoujkneedjktojkrejkleverjktojkreflectjkthejkrealjkriskjkofjkthejkcompanyjkinjkthejkCOEjkcalc.

Wouldjkyoujkexpectjkajkmanufacturingjkcompanyjkorjkajktechnologyjkcompanyjktojkhavejkhig
herjkBeta?jk-jkanswer--Techjkbecausejktheyjkarejkviewedjkasjk"riskier"

IfjkyoujkleveredjkFCFjkwhatjkshouldjkyoujkusejkasjkajkdiscountjkrate?jk-jkanswer--
YoujkshouldjkusejkthejkCOEjkratherjkthanjkWACCjksincejkdebtjkisjknotjkinvolvedjkinjkthejkFCF.j
kCalculatingjkequityjkvaluejknotjkEV.



HowjkdojkyoujkcalculatejkTerminaljkValue?jk-jkanswer--
Youjkcanjkeitherjkapplyjkajkexitjkmultiplejktojkthejkcompany'sjk5jkyearjkEBITDA,jkEBITjkorjkFC
FjkorjkyoujkcanjkusejkthejkGordonjkGrowthjkmethodjkbasedjkonjkitsjkgrowthjkratejkinjkperpetuit
y.

GGMjkformulajk=jkTerminaljkvalue=jk5jkYearjkFCF*(1+jkgrowthjkrate)/(DiscountjkRate-
GrowthjkRate)

WhyjkwouldjkyoujkusejkGGMjkratherjkthanjkMultiplesjktojkcalculatejkTerminaljkValue?jk-
jkanswer--

Multiplesjkarejkreadilyjkavailablejkforjkmostjkcompaniesjksojktheyjkarejkalmostjkalwaysjkusedj
kvsjkthejkGGM.



YoujkmayjkusejkGordonjkGrowthjkMethodjkifjkyoujkhavejknojkgoodjkcomparablejkcompaniesjk
orjkthejkmultiplesjkmayjkchangejksignificantlyjklikejkajkcyclicaljkindustry.

LetsjksayjkthatjkyoujkusejkLeveredjkFCFjkratherjkthanjkUnleveredjkinjkajkDCF.jkWhatjkisjkthejke
ffect?jk-jkanswer--
LeveredjkFCFjkgivesjkyoujkequityjkvaluejkratherjkthanjkEVjksincejkthejkcashjkflowjkisjkonlyjkav
ailablejktojkthejkequityjkinvestors.

What'sjkanjkappropriatejkgrowthjkratejktojkusejkwhenjkcalculatingjkTerminaljkValue?jk-
jkanswer--