BIWS DCF EXAM QUESTIONS WITH
REVIEWED 100% CORRECT
DETAILED ANSWERS
How can we calculate Cost of Equity WITHOUT using CAPM? - Answer-There is an
alternate formula:
Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends
This is less common than the "standard" formula but sometimes you use it for
companies where dividends are more important or when you lack proper information on
Beta and the other variables that go into calculating Cost of Equity with CAPM
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 holders would be paid
first in a liquidation or bankruptcy scenario.
• Intuitively, interest rates on debt are usually lower than the Cost of Equity numbers you
see (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 will.
Which has a greater impact on a company's DCF valuation - a 10% change in revenue
or a 1% change in the discount rate? - Answer-You should start by saying, "it depends"
but most of the time the 10% difference in revenue will have more of an impact. That
change in revenue doesn't affect only the current year's revenue, but also the
revenue/EBITDA far into the future and even the terminal value.
What about a 1% change in revenue vs. a 1% change in the discount rate? - Answer-In
this case the discount rate is likely to have a bigger impact on the valuation, though the
correct answer should start with, "It could go either way, but most of the time..."
Why would you not use a DCF for a bank or other financial institution? - Answer-Banks
use debt differently than other companies and do not re-invest it in the business - they
use it to create their "products" - loans - instead. Also, interest is a critical part of banks'
, business models and changes in working capital can be much larger than a bank's net
income - so traditional measures of cash flow don't tell you much.
For financial institutions, it's more common to use a Dividend Discount Model or
Residual Income Model instead of a DCF
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-Trick question. You don't
account for this at all in an Unlevered DCF, because paying off debt principal shows up
in Cash Flow from Financing on the Cash Flow Statement - but we only take into
account EBIT * (1 - Tax Rate), and then a few items from Cash Flow from Operations,
and then subtract Capital Expenditures to get to Unlevered Free Cash Flow.
If we were looking at Levered Free Cash Flow, then our interest expense would decline
in future years due to the principal being paid off - the mandatory debt repayments
would also reduce Levered Free Cash Flow (note: some people define Levered FCF
differently, but if you think about it, repaying debt really does reduce the cash flow that
can go to equity investors so it should be subtracted out here).
When you walk through a DCF in interviews, you should divide it into steps and say
something like this: - Answer-"In a DCF analysis, you value a company with the Present
Value of its Free Cash Flows plus the Present Value of its Terminal Value. You can
divide the process into 6 steps:
1. Project a company's Free Cash Flows over a 5-10 year period.
2. Calculate the company's Discount Rate, usually using WACC (Weighted Average
Cost of Capital).
3. Discount and sum up the company's Free Cash Flows.
4. Calculate the company's Terminal Value.
5. Discount the Terminal Value to its Present Value.
6. Add the discounted Free Cash Flows to the discounted Terminal Value."
How do you project Free Cash Flow? The first step is to decide which kind of Free Cash
Flow you need: - Answer-Unlevered FCF (Free Cash Flow to Firm), which excludes net
interest expense and mandatory debt repayments, or
Levered FCF (Free Cash Flow to Equity), which includes net interest expense and
mandatory debt repayments.
99% of the time you care about Unlevered FCF, which is good news because it's much
easier to calculate.
rules to calculate CF changes: Change in Operating Assets and Liabilities, otherwise
known as the Change in Working Capital or Change in Operating Working Capital. -
Answer-• If an Asset goes up, cash flow goes down...
• If an Asset goes down, cash flow goes up...
REVIEWED 100% CORRECT
DETAILED ANSWERS
How can we calculate Cost of Equity WITHOUT using CAPM? - Answer-There is an
alternate formula:
Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends
This is less common than the "standard" formula but sometimes you use it for
companies where dividends are more important or when you lack proper information on
Beta and the other variables that go into calculating Cost of Equity with CAPM
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 holders would be paid
first in a liquidation or bankruptcy scenario.
• Intuitively, interest rates on debt are usually lower than the Cost of Equity numbers you
see (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 will.
Which has a greater impact on a company's DCF valuation - a 10% change in revenue
or a 1% change in the discount rate? - Answer-You should start by saying, "it depends"
but most of the time the 10% difference in revenue will have more of an impact. That
change in revenue doesn't affect only the current year's revenue, but also the
revenue/EBITDA far into the future and even the terminal value.
What about a 1% change in revenue vs. a 1% change in the discount rate? - Answer-In
this case the discount rate is likely to have a bigger impact on the valuation, though the
correct answer should start with, "It could go either way, but most of the time..."
Why would you not use a DCF for a bank or other financial institution? - Answer-Banks
use debt differently than other companies and do not re-invest it in the business - they
use it to create their "products" - loans - instead. Also, interest is a critical part of banks'
, business models and changes in working capital can be much larger than a bank's net
income - so traditional measures of cash flow don't tell you much.
For financial institutions, it's more common to use a Dividend Discount Model or
Residual Income Model instead of a DCF
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-Trick question. You don't
account for this at all in an Unlevered DCF, because paying off debt principal shows up
in Cash Flow from Financing on the Cash Flow Statement - but we only take into
account EBIT * (1 - Tax Rate), and then a few items from Cash Flow from Operations,
and then subtract Capital Expenditures to get to Unlevered Free Cash Flow.
If we were looking at Levered Free Cash Flow, then our interest expense would decline
in future years due to the principal being paid off - the mandatory debt repayments
would also reduce Levered Free Cash Flow (note: some people define Levered FCF
differently, but if you think about it, repaying debt really does reduce the cash flow that
can go to equity investors so it should be subtracted out here).
When you walk through a DCF in interviews, you should divide it into steps and say
something like this: - Answer-"In a DCF analysis, you value a company with the Present
Value of its Free Cash Flows plus the Present Value of its Terminal Value. You can
divide the process into 6 steps:
1. Project a company's Free Cash Flows over a 5-10 year period.
2. Calculate the company's Discount Rate, usually using WACC (Weighted Average
Cost of Capital).
3. Discount and sum up the company's Free Cash Flows.
4. Calculate the company's Terminal Value.
5. Discount the Terminal Value to its Present Value.
6. Add the discounted Free Cash Flows to the discounted Terminal Value."
How do you project Free Cash Flow? The first step is to decide which kind of Free Cash
Flow you need: - Answer-Unlevered FCF (Free Cash Flow to Firm), which excludes net
interest expense and mandatory debt repayments, or
Levered FCF (Free Cash Flow to Equity), which includes net interest expense and
mandatory debt repayments.
99% of the time you care about Unlevered FCF, which is good news because it's much
easier to calculate.
rules to calculate CF changes: Change in Operating Assets and Liabilities, otherwise
known as the Change in Working Capital or Change in Operating Working Capital. -
Answer-• If an Asset goes up, cash flow goes down...
• If an Asset goes down, cash flow goes up...
