Discounted Cash Flows Exam Questions With Verified Solutions

Discounted Cash Flows Exam Questions With Verified Solutions A DCF values a company based on: - answerThe present value of its cash flows and the present value of its terminal value. Walk me through a DCF - answerFirst, you project out the company's financials using assumptions for revenue growth, expenses and working capital. Then you get FCF for each year which you sum up and discount to a NPV based on your discount rate, usually the WACC. Then you determine the company's terminal value using either the multiples method or the Gordon Growth Method and dicount that back to NPV using WACC. Add the two together to get the estimated EV. How do you get from revenue to FCF? - answerRevenue-COGS-Operating Expenses to get to EBIT. Then multiply by (1-Tax Rate), add back Depreciation and other non-cash charges and subtract CAPEX and the change in Working Capital. (This is unlevered FCF since we went off of EBIT rather than EBT). What is an alternate way to calculate FCF aside from taking NI, adding DEP and subtracting CAPEX? - answerTake CF from operations and subtract CAPEX to get levered CF. To get unlevered you need to add back the tax adjusted interest expense and subtract tax adjusted interest income. Why do you use 5 or 10 years for a DCF? - answerAnything beyond 10 years is too difficult to predict for most companies. What do you usually use for the discount rate? - answerWACC, although you could use Cost of Equity. How do you calculate WACC? - answerCost of Equity *% of capital structure composed of equity+ cost of debt* % of capital structure composed of debt*(1-tax rate) + cost of preferred*% of capital structure composed of preferred How do you calculate cost of equity - answerUse the Capital Asset Pricing Model = Risk free rate +beta *Equity risk premium What is the Risk free rate - answerTypically the yield on 10 or 20 year T-bond What is risk premiuim - answerThe % by which stocks are expected to out-perform risk-less assets How do you get Beta in the Cost of Equity calculation? - answerUnlevered 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? - answerLevered 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? - answerA technology company