Discounted Cash Flow Model Final Exam Questions and Correct Answers 2024

Discounted Cash Flow Model Final Exam Questions and Correct Answers 2024 How do you get Beta in the Cost of Equity calculation? Unlevered beta= levered beta/ (1+ (1-tax rate)*(total debt/total equity) Levered Beta= unlevered beta (1+ (1-Tax rate) (total debt/total equity) Why do you have to un-lever and re-lever beta? Levered beta reflects the debt already assumed by each company but since each company's capital structure is different and if we want to see how risky the company is regardless of debt structure then we must un-lever the beta. In the end beta will be re-levered because we want the cost of equity to reflect the true risk Which would you expect to have a higher beta a tech company or a manufacturing company? A technology company because the technology industry is seen as riskier than the manufacturing industry What is the effect of using levered cash flow vs unlevered cash flow in your DCF? Levered cash flow gives you equity value rather than enterprise value since the cash flow is only available to equity investors (debt investors have already been paid with interest payments) If you use levered FCF what should you use as the discount rate? You would use the cost of equity rather than the WACC since we are not concerned with the debt or preferred stock in this case How do you calculate terminal value? You can either use the multiples method in which you apply an exit multiple to the company's year 5 EBITDA, EBIT or FCF or you can use the Gordon Growth method to estimate its value based on its growth rate into perpetuity Gordon Growth Method equation: Terminal value= year 5 FCF*(1+growth rate)/ (discount rate- growth rate) Why would you use the Gordon Method over the multiples method? In banking, you almost always use the multiples method as it is much easier to get data on exit multiples since they are based on comparable companies. Picking a long term growth rate is always a shot in the dark. You might use the GGM if you have no good comparable. What is an appropriate growth rate to use for terminal value? Typically the nation's long term GDP growth rate, rate of inflation or something similar that is conservative. Anything over 5% would be seen as very aggressive. How do you select appropriate exit multiples when calculating Terminal Value? Normally you look at comparable companies and pick the median of the set. You would want to select a range of exit multiples and show what the TV looks like over that range. For example if the median EBITDA multiple is 8x you would want to show all TV from 6x to 10x Which method of calculating terminal value will give you a higher valuation? Both are highly dependent on the assumptions you make, but typically the multiples method because exit multiples span a larger range than long-term growth rates What is the flaw in basing terminal multiples on what public comparable are trading at? The median multiples could change greatly in the next 5-10 years so it may no longer be accurate to assume those multiples. How do you know if your DCF is too dependent on future assumptions? If significantly more than 50% of your company EV comes from its terminal value then it is probably too dependent. In reality most all DCF's are too dependent on future assumptions and it is rare to find one in which terminal value is less than 50% of EV. When it gets to be 80- 90% however, you may need to rethink some assumptions. Should cost of equity be higher for a $5b or a $500m market cap company? It should be higher for the $500m company because small cap companies, in general, are expected to outperform large cap companies, although they are more risky. Will WACC be higher for a $5b or a $500m market cap company? This is highly dependent upon if the capital structure is the same for both companies. If it is the same in terms of interest rates and percentages then it should be higher for the $500m company because it would typically be expected to outperform the large cap company. If it is not the same then it could go either way depending on much debt/preferred stock each one has and what its interest rates are. What is the relationship between debt and the cost of equity? More debt means the company will be more risky thus driving its levered beta higher. All els