BIWS DCF EXAM QUESTIONS WITH
ALL CORRECT ANSWERS
How does the tax rate affect the Cost of Equity, Cost of Debt, WACC, and the Implied
Value from a DCF? - Answer-The tax rate affects the Cost of Equity, Cost of Debt, and
WACC only if the company has Debt. If the company does not have Debt, or its
targeted/optimal capital structure does not include Debt, the tax rate doesn't matter
because there's no tax benefit to interest paid on Debt.
If the company has some Debt, a higher tax rate will reduce the Cost of Equity, Cost of
Debt, and WACC.
It's easy to see why it reduces the Cost of Debt: Since you multiply by (1 - Tax Rate), a
higher rate always reduces the after-tax cost.
But it also reduces the Cost of Equity for the same reason: With a greater tax benefit,
Debt is less risky even to Equity investors. And if both of these are lower, WACC will
also be lower.
However, the Implied Value from a DCF will also be lower because the higher tax rate
reduces FCF and the company's Terminal Value. Those changes outweigh a lower
WACC.
The opposite happens with a lower tax rate: The Cost of Equity, Cost of Debt, and
WACC are all higher, and the Implied Value is also higher.
Can you walk me through how you use Public Comps and Precedent Transactions in a
valuation? - Answer-First, you select the companies and transactions based on criteria
such as industry, size, and geography (and time for the transactions).
Then, you determine the appropriate metrics and multiples for each set - for example,
revenue, revenue growth, EBITDA, EBITDA margins, and revenue and EBITDA
multiples - and you calculate them for all the companies and transactions.
Next, you calculate the minimum, 25th percentile, median, 75th percentile, and
maximum for each valuation multiple in the set.
Finally, you apply these numbers to the financial metrics of the company you're
analyzing to estimate its Implied Value.
For example, if the company you're valuing has $100 million in LTM EBITDA, and the
median LTM EV / EBITDA multiple in a set of comparable companies is 7x, then the
company's implied Enterprise Value is $700 million.
You then calculate its Implied Value for all the other multiples to get a range of possible
values.
Why is it important to select Public Comps and Precedent Transactions that are similar?
- Answer-Because the comparable companies and transactions should have similar
Discount Rates and Free Cash Flow figures.
,Remember that a company's valuation multiples depend on its Free Cash Flow,
Discount Rate, and Expected FCF Growth Rate.
If the companies in your set all have similar Discount Rates and Free Cash Flows, it's
easier to conclude that one company trades at higher multiples because its expected
growth rate is higher.
If the companies do not have similar Discount Rates and Free Cash Flows, it's harder to
draw meaningful conclusions.
How do you select Comparable Companies and Precedent Transactions? - Answer-You
screen based on geography, industry, and size, and also time for Precedent
Transactions.
Here are a few example screens:
• Comparable Company Screen: U.S.-based steel manufacturing companies with over
$500 million in revenue.
• Comparable Company Screen: European legacy airlines with over €1 billion in
EBITDA.
• Precedent Transaction Screen: Latin American M&A transactions over the past 3
years involving consumer/retail sellers with over $1 billion USD in revenue.
• Precedent Transaction Screen: Australian M&A transactions over the past 2 years
involving infrastructure sellers with over $200 million AUD in revenue.
Are there any screens you should AVOID when selecting Comparable Companies and
Precedent Transactions? - Answer-You should avoid screening by both financial metrics
and Equity Value or Enterprise Value.
For example, you should NOT use this screen: "Companies with revenue below $1
billion and Enterprise Values above $2 billion."
If you use that screen, you're artificially constraining the multiples because EV /
Revenue must be above 2x for every company in the set.
Public Comps and Precedent Transactions seem similar. What are the main
differences? - Answer-The idea is similar - you use Current valuation multiples from
similar companies or deals to value a company - but the execution is different.
Here are the differences for Precedent Transactions:
• Screening Criteria: In addition to industry, size, and geography, you also use time
because you only want transactions from the past few years. You might also use
Transaction Size, and you might use broader screening criteria in general.
• Metrics and Multiples: You focus on historical metrics and multiples, especially LTM
revenue and EBITDA as of the announcement date.
• Calculations: All the multiples are based on the purchase price as of the
announcement date of the deal.
What's the point of valuation? WHY do you value a company? - Answer-You value a
company to determine its Implied Value according to your views of it.
If this Implied Value is very different from the company's Current Value, you might be
able to invest in the company and make money if its value changes.
, If you are advising a client company, you might value it so you can tell management the
price that it might receive if the company sells, which is often different from its Current
Value.
But public companies already have Market Caps and Share Prices. Why bother valuing
them? - Answer-Because a company's Market Cap and Share Price reflect its Current
Value according to "the market as a whole" - but the market might be wrong!
You value companies to see if the market's views are correct or incorrect.
What are the advantages and disadvantages of the 3 main valuation methodologies? -
Answer-Public Comps are useful because they're based on real market data, are quick
to calculate and explain, and do not depend on far-in-the-future assumptions.
However, there may not be truly comparable companies, the analysis will be less
accurate for volatile or thinly traded companies, and it may undervalue companies' long-
term potential.
Precedent Transactions are useful because they're based on the real prices that
companies have paid for other companies, and they may better reflect industry trends
than Public Comps.
However, the data is often spotty and misleading, there may not be truly comparable
transactions, and specific deal terms and market conditions might distort the multiples.
DCF Analysis is the most "correct" methodology according to finance theory, it's less
subject to market fluctuations, and it better reflects company-specific factors and long-
term trends.
However, it's also very dependent on far-in-the-future assumptions, and there's
disagreement over the proper calculations for key figures like the Cost of Equity and
WACC.
Which of the 3 main methodologies will produce the highest Implied Values? - Answer-
This is a trick question because almost any methodology could produce the highest
Implied Values depending on the industry, time period, and assumptions.
Precedent Transactions often produce higher Implied Values than the Public Comps
because of the control premium - the extra amount that acquirers must pay to acquire
sellers.
But it's tough to say how a DCF stacks up because it's far more dependent on your
assumptions.
The best answer is: "A DCF tends to produce the most variable output since it's so
dependent on your assumptions, and Precedent Transactions tend to produce higher
values than the Public Comps because of the control premium."
When is a DCF more useful than Public Comps or Precedent Transactions? - Answer-
You should pretty much always build a DCF since it IS valuation - the other
methodologies are supplemental.
But it's especially useful when the company you're valuing is mature and has stable,
predictable cash flows, or when you lack good Public Comps or Precedent
Transactions.
ALL CORRECT ANSWERS
How does the tax rate affect the Cost of Equity, Cost of Debt, WACC, and the Implied
Value from a DCF? - Answer-The tax rate affects the Cost of Equity, Cost of Debt, and
WACC only if the company has Debt. If the company does not have Debt, or its
targeted/optimal capital structure does not include Debt, the tax rate doesn't matter
because there's no tax benefit to interest paid on Debt.
If the company has some Debt, a higher tax rate will reduce the Cost of Equity, Cost of
Debt, and WACC.
It's easy to see why it reduces the Cost of Debt: Since you multiply by (1 - Tax Rate), a
higher rate always reduces the after-tax cost.
But it also reduces the Cost of Equity for the same reason: With a greater tax benefit,
Debt is less risky even to Equity investors. And if both of these are lower, WACC will
also be lower.
However, the Implied Value from a DCF will also be lower because the higher tax rate
reduces FCF and the company's Terminal Value. Those changes outweigh a lower
WACC.
The opposite happens with a lower tax rate: The Cost of Equity, Cost of Debt, and
WACC are all higher, and the Implied Value is also higher.
Can you walk me through how you use Public Comps and Precedent Transactions in a
valuation? - Answer-First, you select the companies and transactions based on criteria
such as industry, size, and geography (and time for the transactions).
Then, you determine the appropriate metrics and multiples for each set - for example,
revenue, revenue growth, EBITDA, EBITDA margins, and revenue and EBITDA
multiples - and you calculate them for all the companies and transactions.
Next, you calculate the minimum, 25th percentile, median, 75th percentile, and
maximum for each valuation multiple in the set.
Finally, you apply these numbers to the financial metrics of the company you're
analyzing to estimate its Implied Value.
For example, if the company you're valuing has $100 million in LTM EBITDA, and the
median LTM EV / EBITDA multiple in a set of comparable companies is 7x, then the
company's implied Enterprise Value is $700 million.
You then calculate its Implied Value for all the other multiples to get a range of possible
values.
Why is it important to select Public Comps and Precedent Transactions that are similar?
- Answer-Because the comparable companies and transactions should have similar
Discount Rates and Free Cash Flow figures.
,Remember that a company's valuation multiples depend on its Free Cash Flow,
Discount Rate, and Expected FCF Growth Rate.
If the companies in your set all have similar Discount Rates and Free Cash Flows, it's
easier to conclude that one company trades at higher multiples because its expected
growth rate is higher.
If the companies do not have similar Discount Rates and Free Cash Flows, it's harder to
draw meaningful conclusions.
How do you select Comparable Companies and Precedent Transactions? - Answer-You
screen based on geography, industry, and size, and also time for Precedent
Transactions.
Here are a few example screens:
• Comparable Company Screen: U.S.-based steel manufacturing companies with over
$500 million in revenue.
• Comparable Company Screen: European legacy airlines with over €1 billion in
EBITDA.
• Precedent Transaction Screen: Latin American M&A transactions over the past 3
years involving consumer/retail sellers with over $1 billion USD in revenue.
• Precedent Transaction Screen: Australian M&A transactions over the past 2 years
involving infrastructure sellers with over $200 million AUD in revenue.
Are there any screens you should AVOID when selecting Comparable Companies and
Precedent Transactions? - Answer-You should avoid screening by both financial metrics
and Equity Value or Enterprise Value.
For example, you should NOT use this screen: "Companies with revenue below $1
billion and Enterprise Values above $2 billion."
If you use that screen, you're artificially constraining the multiples because EV /
Revenue must be above 2x for every company in the set.
Public Comps and Precedent Transactions seem similar. What are the main
differences? - Answer-The idea is similar - you use Current valuation multiples from
similar companies or deals to value a company - but the execution is different.
Here are the differences for Precedent Transactions:
• Screening Criteria: In addition to industry, size, and geography, you also use time
because you only want transactions from the past few years. You might also use
Transaction Size, and you might use broader screening criteria in general.
• Metrics and Multiples: You focus on historical metrics and multiples, especially LTM
revenue and EBITDA as of the announcement date.
• Calculations: All the multiples are based on the purchase price as of the
announcement date of the deal.
What's the point of valuation? WHY do you value a company? - Answer-You value a
company to determine its Implied Value according to your views of it.
If this Implied Value is very different from the company's Current Value, you might be
able to invest in the company and make money if its value changes.
, If you are advising a client company, you might value it so you can tell management the
price that it might receive if the company sells, which is often different from its Current
Value.
But public companies already have Market Caps and Share Prices. Why bother valuing
them? - Answer-Because a company's Market Cap and Share Price reflect its Current
Value according to "the market as a whole" - but the market might be wrong!
You value companies to see if the market's views are correct or incorrect.
What are the advantages and disadvantages of the 3 main valuation methodologies? -
Answer-Public Comps are useful because they're based on real market data, are quick
to calculate and explain, and do not depend on far-in-the-future assumptions.
However, there may not be truly comparable companies, the analysis will be less
accurate for volatile or thinly traded companies, and it may undervalue companies' long-
term potential.
Precedent Transactions are useful because they're based on the real prices that
companies have paid for other companies, and they may better reflect industry trends
than Public Comps.
However, the data is often spotty and misleading, there may not be truly comparable
transactions, and specific deal terms and market conditions might distort the multiples.
DCF Analysis is the most "correct" methodology according to finance theory, it's less
subject to market fluctuations, and it better reflects company-specific factors and long-
term trends.
However, it's also very dependent on far-in-the-future assumptions, and there's
disagreement over the proper calculations for key figures like the Cost of Equity and
WACC.
Which of the 3 main methodologies will produce the highest Implied Values? - Answer-
This is a trick question because almost any methodology could produce the highest
Implied Values depending on the industry, time period, and assumptions.
Precedent Transactions often produce higher Implied Values than the Public Comps
because of the control premium - the extra amount that acquirers must pay to acquire
sellers.
But it's tough to say how a DCF stacks up because it's far more dependent on your
assumptions.
The best answer is: "A DCF tends to produce the most variable output since it's so
dependent on your assumptions, and Precedent Transactions tend to produce higher
values than the Public Comps because of the control premium."
When is a DCF more useful than Public Comps or Precedent Transactions? - Answer-
You should pretty much always build a DCF since it IS valuation - the other
methodologies are supplemental.
But it's especially useful when the company you're valuing is mature and has stable,
predictable cash flows, or when you lack good Public Comps or Precedent
Transactions.
