IB Discounted Cash Flow Questions and
100% Correct Answers
How to calculate WACC? ✅WACC= Cost of Equity * (%Equity) + Cost of Debt * (%
Debt) *(1-tax) + Cost of Preferred*(%preferred)
How to calculate cost of equity? ✅Cost of equity = Risk-Free Rate + Beta * Equity Risk
Premium
How to get to Beta in the Cost of Equity Calculation? ✅1. find Beta for each
comparable company, unlever each one, take the media of the set, and lever it based
on company's capital structure
Unlevered Beta = Levered Beta / (1+((1-Tax Rate)*(Total Debt/Equity)))
Levered Beta = Un-Levered beta x (1+((1-Tax Rate)*(Total Debt/Equity)
Why do you have to unlever and re-lever Beta? ✅When you look up Betas, they will be
levered to reflect the debt assumed by a company.
But each company's capital structure is different and we want to look at how risk a
company is regardless of what % of debt or equity it has.
But at the end, we need to re-lever the beta because we want the Beta used in the cost
of equity calculation to reflect the true risk of the company, taking into account its capital
structure.
Would you expect a manufacturing company or a technology company to have a higher
Beta? ✅A technology company, because tech is viewed as riskier industry than
manufacturing
What is the effect of using levered free cash flows vs. unlevered free cash flows in a
DCF? ✅Levered cash flows give equity value rather than the enterprise value since
the cash flow is only available to equity investors.
How to calculate terminal value? ✅1. Multiples Method - apply existing multiple to
company's year 5 EBITDA, EBIT, or Free Cash Flow
2. Gordon Growth Model
Gordon Growth Model formula ✅GGM = Terminal Value = Year 5 free Cash Flow *
(1+g)/Discount rate -g)
, Why use GGM rather than Multiples Method? ✅in banking, almost always use
multiples method. Its much easier to get exit multipled since they are based on
comparable companies.
Use GGM is there are no good comparable companies or if you have reason to believe
that multiples will change significantly down the road.
What's an appropriate growth rate to use when calculating the Terminal Value?
✅country's long-term GDP growth rate, the rate of inflation, or something similarly
conservative.
In mature economies, a long-term growth rate over 5% is aggressive.
How to know if DCF is too dependent on future assumptions? ✅If significantly more
than 50% of company's EV comes from TV, DCF is too dependent.
in reality, almost all DCF's are too dependent on future assumptions.
What's the relationship between debt and Cost of Equity? ✅More debt means that the
compay is more risky, so the company's levered Beta will be higher
Should we factor dividend yield into CAPM? ✅Trick question: dividend yields are
already factored into beta, bc beta describes returns in excess of the market as a whole
- and those returns include dividends.
How to calculate cost of equity without CAPM? ✅Alternate formula:
Re=(Dividends per Share/Share price) + growth rate of dividends
Why would you not use a DCF for a bank or other financial institution? ✅-banks use
debt differently than other companies and do not re-invest it in the business they use it
to create products instead.
Interest is an important part of bank's business models and working capital takes up a
huge part of their balance sheets
more common to use a dividen discount model
When you're calculating WACC, let's say that the company has convertible debt. Do you
count this as debt when calculating Levered Beta for the company? ✅Trick Question: if
the convertible debt is in the money, then you do not count it as debt but instead
assume that it contributes to dilution so the company's Equity Value is higher.
if its out of the money, then you count it as debt and use the interest rate on the
convertible for Cost of Debt
100% Correct Answers
How to calculate WACC? ✅WACC= Cost of Equity * (%Equity) + Cost of Debt * (%
Debt) *(1-tax) + Cost of Preferred*(%preferred)
How to calculate cost of equity? ✅Cost of equity = Risk-Free Rate + Beta * Equity Risk
Premium
How to get to Beta in the Cost of Equity Calculation? ✅1. find Beta for each
comparable company, unlever each one, take the media of the set, and lever it based
on company's capital structure
Unlevered Beta = Levered Beta / (1+((1-Tax Rate)*(Total Debt/Equity)))
Levered Beta = Un-Levered beta x (1+((1-Tax Rate)*(Total Debt/Equity)
Why do you have to unlever and re-lever Beta? ✅When you look up Betas, they will be
levered to reflect the debt assumed by a company.
But each company's capital structure is different and we want to look at how risk a
company is regardless of what % of debt or equity it has.
But at the end, we need to re-lever the beta because we want the Beta used in the cost
of equity calculation to reflect the true risk of the company, taking into account its capital
structure.
Would you expect a manufacturing company or a technology company to have a higher
Beta? ✅A technology company, because tech is viewed as riskier industry than
manufacturing
What is the effect of using levered free cash flows vs. unlevered free cash flows in a
DCF? ✅Levered cash flows give equity value rather than the enterprise value since
the cash flow is only available to equity investors.
How to calculate terminal value? ✅1. Multiples Method - apply existing multiple to
company's year 5 EBITDA, EBIT, or Free Cash Flow
2. Gordon Growth Model
Gordon Growth Model formula ✅GGM = Terminal Value = Year 5 free Cash Flow *
(1+g)/Discount rate -g)
, Why use GGM rather than Multiples Method? ✅in banking, almost always use
multiples method. Its much easier to get exit multipled since they are based on
comparable companies.
Use GGM is there are no good comparable companies or if you have reason to believe
that multiples will change significantly down the road.
What's an appropriate growth rate to use when calculating the Terminal Value?
✅country's long-term GDP growth rate, the rate of inflation, or something similarly
conservative.
In mature economies, a long-term growth rate over 5% is aggressive.
How to know if DCF is too dependent on future assumptions? ✅If significantly more
than 50% of company's EV comes from TV, DCF is too dependent.
in reality, almost all DCF's are too dependent on future assumptions.
What's the relationship between debt and Cost of Equity? ✅More debt means that the
compay is more risky, so the company's levered Beta will be higher
Should we factor dividend yield into CAPM? ✅Trick question: dividend yields are
already factored into beta, bc beta describes returns in excess of the market as a whole
- and those returns include dividends.
How to calculate cost of equity without CAPM? ✅Alternate formula:
Re=(Dividends per Share/Share price) + growth rate of dividends
Why would you not use a DCF for a bank or other financial institution? ✅-banks use
debt differently than other companies and do not re-invest it in the business they use it
to create products instead.
Interest is an important part of bank's business models and working capital takes up a
huge part of their balance sheets
more common to use a dividen discount model
When you're calculating WACC, let's say that the company has convertible debt. Do you
count this as debt when calculating Levered Beta for the company? ✅Trick Question: if
the convertible debt is in the money, then you do not count it as debt but instead
assume that it contributes to dilution so the company's Equity Value is higher.
if its out of the money, then you count it as debt and use the interest rate on the
convertible for Cost of Debt
