DCF INTERVIEW QUESTIONS
A company has a high Debt balance and is paying off a significant portion of its
Debt principal each year. How does this impact a DCF? - answer-Trick Question. you
don't account for this at all in an Unlevered DCF because you ignore interest
expense and debt principal repayments.
In a levered DCF you factor it in by reducing the interest expense each year as the
Debt goes down and also by reducing Free Cash Flow by the mandatory repayments
each year.
The exact impact i.e. whether the implied Equity Value goes up or down depends on
the interest rate and the principal repayment percentage each year; however, in
most cases the principal repayments far exceed the net interest expense so the
Equity Value will most likely decrease because Levered FCF will be lower each year.
An alternative to the DCF is the Dividend Discount Model. How is it different in the
general case (i.e. for a normal company,not a commercial bank or insurance firm) -
answer-The setup is similar, you still project revenue and expenses over a 5-10 year
period and you still calculate Terminal Value.
The difference is that you do not calculate Free Cash Flow - you stop at Net Income
and assume that Dividends issued are a percentage of Net Income and then you
discount those dividends back to their present value using the Cost of equity.
Then you add those up and add them to the present value of the Terminal Value
which you might base on a P/E multiple instead.
Finally, a DDM gets you the company's Equity Value rather than its Enterprise Value
since you're using metrics that include interest income and expense.
Are you saying that a company that does not take on Debt is at a disadvantage to
one that does? how does that make sense? - answer-The one without Debt is not "at
a disadvantage" but it wont be valued as highly because of the way the WACC
formula works.
Keep in mind that companies do not make big decisions based on financial
formulas. If a company has no reason to take on Debt then it wont take it on.
As an approximation do you think its OK to use EBITA- Changes in Operating Assets
and Liabilities - CapEx to approximate Unlevered FCF? - answer-This is inaccurate
because it excludes taxes completely.
Taxes are significant and should not be overlooked.
Can Beta ever be negative? What would that mean? - answer-Theoretically, yes,
Beta could be negative for certain assets. If Beta is -1, for example, that would
mean that the asset moves in the opposite direction from the market as a whole.
, In practice, you rarely if ever see negative Betas with real companies. Even
something labeled as counter cyclical still follows the market as a whole, a counter-
cyclical company might have a Beta of 0.5 or 0.7 but not -1
Can you explain the Gordon Growth formula in more detail? What's the intuition
behind it? - answer-Terminal Value = Final Year Free Cash Flow * (1+ Growth
Rate)/(Discount Rate - Growth Rate)
Intuition:
Let's say that we know for certain that we'll receive $100 every year indefinitely,
and we have a required return of 10%.
That means that we can afford to pay $1000 now to receive $100 in year 1 and
$100 in every year after that forever.
But let's say that the stream of $100 were actually growing each year - if that's the
case, then we could afford to invest more than the initial $1,000.
Let's say that we expect the $100 to grow by 5% every year - how much can we
afford to pay now to capture all those future payments, if our required return is
10%?
Well that growth increases our effective return so now we can pay more and still get
that same 10% return.
We can estimate that by dividing the $100 by (10%-5%). 10% is our required return
and 5% is the growth rate. So in this case $100/(10%-5%)= $2000.
This corresponds to the formula above: $100 represents Final Year Free Cash Flow *
(1+Growth Rate), 10% is the discount rate, and 5% is the growth rate.
The higher the expected growth the more we can afford to pay upfront. And if the
expected growth is the same as the required return theoretically we can pay an
infinite amount to achieve that return.
Cost of Equity tells us the return that an equity investor might expect for investing
in a given company but what about dividends. Shouldn't we factor dividend yield
into the formula. - answer-Dividend yields are already factored into Beta, because
beta describes returns in excess of the market as a whole and those returns include
dividends.
How can we calculate Cost of Equity without using CAPM? - answer-Here 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 when the
company is guaranteed to issue dividends (Utilities companies) and/or information
on Beta is unreliable.
A company has a high Debt balance and is paying off a significant portion of its
Debt principal each year. How does this impact a DCF? - answer-Trick Question. you
don't account for this at all in an Unlevered DCF because you ignore interest
expense and debt principal repayments.
In a levered DCF you factor it in by reducing the interest expense each year as the
Debt goes down and also by reducing Free Cash Flow by the mandatory repayments
each year.
The exact impact i.e. whether the implied Equity Value goes up or down depends on
the interest rate and the principal repayment percentage each year; however, in
most cases the principal repayments far exceed the net interest expense so the
Equity Value will most likely decrease because Levered FCF will be lower each year.
An alternative to the DCF is the Dividend Discount Model. How is it different in the
general case (i.e. for a normal company,not a commercial bank or insurance firm) -
answer-The setup is similar, you still project revenue and expenses over a 5-10 year
period and you still calculate Terminal Value.
The difference is that you do not calculate Free Cash Flow - you stop at Net Income
and assume that Dividends issued are a percentage of Net Income and then you
discount those dividends back to their present value using the Cost of equity.
Then you add those up and add them to the present value of the Terminal Value
which you might base on a P/E multiple instead.
Finally, a DDM gets you the company's Equity Value rather than its Enterprise Value
since you're using metrics that include interest income and expense.
Are you saying that a company that does not take on Debt is at a disadvantage to
one that does? how does that make sense? - answer-The one without Debt is not "at
a disadvantage" but it wont be valued as highly because of the way the WACC
formula works.
Keep in mind that companies do not make big decisions based on financial
formulas. If a company has no reason to take on Debt then it wont take it on.
As an approximation do you think its OK to use EBITA- Changes in Operating Assets
and Liabilities - CapEx to approximate Unlevered FCF? - answer-This is inaccurate
because it excludes taxes completely.
Taxes are significant and should not be overlooked.
Can Beta ever be negative? What would that mean? - answer-Theoretically, yes,
Beta could be negative for certain assets. If Beta is -1, for example, that would
mean that the asset moves in the opposite direction from the market as a whole.
, In practice, you rarely if ever see negative Betas with real companies. Even
something labeled as counter cyclical still follows the market as a whole, a counter-
cyclical company might have a Beta of 0.5 or 0.7 but not -1
Can you explain the Gordon Growth formula in more detail? What's the intuition
behind it? - answer-Terminal Value = Final Year Free Cash Flow * (1+ Growth
Rate)/(Discount Rate - Growth Rate)
Intuition:
Let's say that we know for certain that we'll receive $100 every year indefinitely,
and we have a required return of 10%.
That means that we can afford to pay $1000 now to receive $100 in year 1 and
$100 in every year after that forever.
But let's say that the stream of $100 were actually growing each year - if that's the
case, then we could afford to invest more than the initial $1,000.
Let's say that we expect the $100 to grow by 5% every year - how much can we
afford to pay now to capture all those future payments, if our required return is
10%?
Well that growth increases our effective return so now we can pay more and still get
that same 10% return.
We can estimate that by dividing the $100 by (10%-5%). 10% is our required return
and 5% is the growth rate. So in this case $100/(10%-5%)= $2000.
This corresponds to the formula above: $100 represents Final Year Free Cash Flow *
(1+Growth Rate), 10% is the discount rate, and 5% is the growth rate.
The higher the expected growth the more we can afford to pay upfront. And if the
expected growth is the same as the required return theoretically we can pay an
infinite amount to achieve that return.
Cost of Equity tells us the return that an equity investor might expect for investing
in a given company but what about dividends. Shouldn't we factor dividend yield
into the formula. - answer-Dividend yields are already factored into Beta, because
beta describes returns in excess of the market as a whole and those returns include
dividends.
How can we calculate Cost of Equity without using CAPM? - answer-Here 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 when the
company is guaranteed to issue dividends (Utilities companies) and/or information
on Beta is unreliable.
