BIWS DCF EXAM QUESTIONS WITH
REVIEWED CORRECT DETAILED
ANSWERS
What's the flaw with basing the Terminal Multiple on what the Public Comps are trading
at? - Answer-The median multiples may change greatly in the next 5-10 years, so they
may no longer be accurate by the end of the period you're looking at. This is why you
look at a wide range of multiples and run sensitivity analyses to see how these variables
impact the valuation.
Wait a second: why isn't the present value of the Terminal Value, by itself, just the
company's Enterprise Value? Don't you get Enterprise Value if you apply a multiple to
EBITDA? - Answer-Yes, you do get Enterprise Value - but that only represents the
company's "far in the future" value. Remember that in a DCF, a company's value is
divided into "near future" and "far future."
If you leave out the present value of Free Cash Flows in the projection period, you're
saying, "For the next 5 years, this company has no value. But then at the end of year 5,
the company is miraculously worth something again!" And that doesn't make sense.
How do you know if a DCF is too dependent on future assumptions? - Answer-Some
people claim that if over 50% of a company's value comes from the present value of the
Terminal Value, the DCF is too dependent on future assumptions.
The problem, though, is that in practice this is true in almost all DCFs. If the present
value of the Terminal Value accounts for something like 80-90%+ of the company's
value, then maybe you need to re-think your assumptions.
How can you check whether your assumptions for Terminal Value using the Multiples
Method vs. the Gordon Growth Method make sense? - Answer-The most common
method here is to calculate Terminal Value using one method, and then to see what the
implied long-term growth rate or implied multiple via the other method would be.
Example: You calculate Terminal Value with a long-term growth rate assumption of 4%.
Terminal Value is $10,000. You divide that Terminal Value by the final year EBITDA and
get an implied EBITDA multiple of 15x - but the Public Comps are only trading at a
median of 8x EBITDA. In this case your assumption is almost certainly too aggressive
and you should reduce that long- term growth rate.
,You're looking at two companies, both of which produce identical total Free Cash Flows
over a 5-year period. Company A generates 90% of its Free Cash Flow in the first year
and 10% over the remaining 4 years. Company B generates the same amount of Free
Cash Flow in each year.
Which one has the higher net present value? - Answer-Company A, because money
today is worth more than money tomorrow. All else being equal, generating higher cash
flow earlier on will always boost a company's value in a DCF.
Should Cost of Equity be higher for a $5 billion or $500 million Market Cap company? -
Answer-It should be higher for the $500 million company, because all else being equal,
smaller companies are expected to outperform large companies in the stock market
(and are therefore "riskier").
What about WACC - will it be higher for a $5 billion or $500 million company? - Answer-
This is a bit of a trick question because it depends on whether or not the capital
structure is the same for both companies. If the capital structure is the same in terms of
percentages and interest rates, then WACC should be higher for the $500 million
company for the same reasons as mentioned above.
If the capital structure is not the same, then it could go either way depending on how
much debt/preferred stock each one has and what the interest rates are.
What's the relationship between Debt and Cost of Equity? - Answer-More Debt means
that the company is riskier, so the company's Levered Beta will be higher - so all else
being equal, Cost of Equity would increase. Less Debt would decrease Cost of Equity.
Two companies are exactly the same, but one has Debt and one does not - which one
will have the higher WACC? - Answer-The one without Debt will generally have a higher
WACC because Debt is "less expensive" than Equity. Why?
• Interest on Debt is tax-deductible - hence the (1 - Tax Rate) multiplication in the
WACC formula.
• Debt is senior to Equity in a company's capital structure - debt investors would be paid
first in a liquidation or bankruptcy scenario.
• Intuitively, interest rates on Debt are usually lower than Cost of Equity numbers
(usually over 10%). As a result, the Cost of Debt portion of WACC will contribute less to
the total figure than the Cost of Equity portion.
Wait a minute, so are you saying that a company that does not take on Debt is at a
disadvantage to one that does? How does that make sense? - Answer-The one without
Debt is not "at a disadvantage" - but it won't be valued as highly because of the way the
WACC formula works.
, Keep in mind that companies do not make big decisions based financial formulas. If a
company has no reason to take on Debt (e.g. it is very profitable and does not need
funds to expand its business), then it won't take on Debt.
Let's say that we assume 10% revenue growth and a 10% Discount Rate in a DCF
analysis. Which change will have a bigger impact: reducing revenue growth to 9%, or
reducing the Discount Rate to 9%? - Answer-The Discount Rate change will almost
certainly have a bigger impact because that affects everything from the present value of
Free Cash Flows to the present value of Terminal Value - and even a 10% change
makes a huge impact.
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.
Walk me through a DCF. - Answer-"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."
Walk me through how you get from Revenue to Free Cash Flow in the projections. -
Answer-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.
REVIEWED CORRECT DETAILED
ANSWERS
What's the flaw with basing the Terminal Multiple on what the Public Comps are trading
at? - Answer-The median multiples may change greatly in the next 5-10 years, so they
may no longer be accurate by the end of the period you're looking at. This is why you
look at a wide range of multiples and run sensitivity analyses to see how these variables
impact the valuation.
Wait a second: why isn't the present value of the Terminal Value, by itself, just the
company's Enterprise Value? Don't you get Enterprise Value if you apply a multiple to
EBITDA? - Answer-Yes, you do get Enterprise Value - but that only represents the
company's "far in the future" value. Remember that in a DCF, a company's value is
divided into "near future" and "far future."
If you leave out the present value of Free Cash Flows in the projection period, you're
saying, "For the next 5 years, this company has no value. But then at the end of year 5,
the company is miraculously worth something again!" And that doesn't make sense.
How do you know if a DCF is too dependent on future assumptions? - Answer-Some
people claim that if over 50% of a company's value comes from the present value of the
Terminal Value, the DCF is too dependent on future assumptions.
The problem, though, is that in practice this is true in almost all DCFs. If the present
value of the Terminal Value accounts for something like 80-90%+ of the company's
value, then maybe you need to re-think your assumptions.
How can you check whether your assumptions for Terminal Value using the Multiples
Method vs. the Gordon Growth Method make sense? - Answer-The most common
method here is to calculate Terminal Value using one method, and then to see what the
implied long-term growth rate or implied multiple via the other method would be.
Example: You calculate Terminal Value with a long-term growth rate assumption of 4%.
Terminal Value is $10,000. You divide that Terminal Value by the final year EBITDA and
get an implied EBITDA multiple of 15x - but the Public Comps are only trading at a
median of 8x EBITDA. In this case your assumption is almost certainly too aggressive
and you should reduce that long- term growth rate.
,You're looking at two companies, both of which produce identical total Free Cash Flows
over a 5-year period. Company A generates 90% of its Free Cash Flow in the first year
and 10% over the remaining 4 years. Company B generates the same amount of Free
Cash Flow in each year.
Which one has the higher net present value? - Answer-Company A, because money
today is worth more than money tomorrow. All else being equal, generating higher cash
flow earlier on will always boost a company's value in a DCF.
Should Cost of Equity be higher for a $5 billion or $500 million Market Cap company? -
Answer-It should be higher for the $500 million company, because all else being equal,
smaller companies are expected to outperform large companies in the stock market
(and are therefore "riskier").
What about WACC - will it be higher for a $5 billion or $500 million company? - Answer-
This is a bit of a trick question because it depends on whether or not the capital
structure is the same for both companies. If the capital structure is the same in terms of
percentages and interest rates, then WACC should be higher for the $500 million
company for the same reasons as mentioned above.
If the capital structure is not the same, then it could go either way depending on how
much debt/preferred stock each one has and what the interest rates are.
What's the relationship between Debt and Cost of Equity? - Answer-More Debt means
that the company is riskier, so the company's Levered Beta will be higher - so all else
being equal, Cost of Equity would increase. Less Debt would decrease Cost of Equity.
Two companies are exactly the same, but one has Debt and one does not - which one
will have the higher WACC? - Answer-The one without Debt will generally have a higher
WACC because Debt is "less expensive" than Equity. Why?
• Interest on Debt is tax-deductible - hence the (1 - Tax Rate) multiplication in the
WACC formula.
• Debt is senior to Equity in a company's capital structure - debt investors would be paid
first in a liquidation or bankruptcy scenario.
• Intuitively, interest rates on Debt are usually lower than Cost of Equity numbers
(usually over 10%). As a result, the Cost of Debt portion of WACC will contribute less to
the total figure than the Cost of Equity portion.
Wait a minute, so are you saying that a company that does not take on Debt is at a
disadvantage to one that does? How does that make sense? - Answer-The one without
Debt is not "at a disadvantage" - but it won't be valued as highly because of the way the
WACC formula works.
, Keep in mind that companies do not make big decisions based financial formulas. If a
company has no reason to take on Debt (e.g. it is very profitable and does not need
funds to expand its business), then it won't take on Debt.
Let's say that we assume 10% revenue growth and a 10% Discount Rate in a DCF
analysis. Which change will have a bigger impact: reducing revenue growth to 9%, or
reducing the Discount Rate to 9%? - Answer-The Discount Rate change will almost
certainly have a bigger impact because that affects everything from the present value of
Free Cash Flows to the present value of Terminal Value - and even a 10% change
makes a huge impact.
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.
Walk me through a DCF. - Answer-"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."
Walk me through how you get from Revenue to Free Cash Flow in the projections. -
Answer-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.
