Discounted Cash Flow

. What's an appropriate growth rate to use when calculating the Terminal Value? - answer-Commonly, we use the country's long term GDP growth rate or rate of inflation (usually something converservative) . Why would you use the Gordon Growth Method rather than the Multiples Method to calculate the Terminal Value? - answer-There may be a few reasons why we may want to use the gordon growth method. 1) if there are no good comparable companies 2) if the industry is cyclical, it may be better to use the long term growth rate instead of the exit multiples (Note: In banking, we always want to use the multiples method to find the terminal value because it does not involve estimating the growth rate) A company has a high debt load and is paying off a significant portion of its principal each year. How do you account for this in a DCF? - answer-Since paying off the principle is an financing activity, the DCF is not affected. It would simply show up on the Cash flow statement. An alternative to the DCF is the Dividend Discount Model (DDM). How is it different in the general case (i.e. for a normal company, not a commercial bank or insurance firm?) - answer-1) Project revenue and expenses for 5-10 years and find the terminal value 2) Instead of finding FCF, we find dividends issued by assuming dividend as a percentage of net income. 3) Discount the dividends and the terminal value back to present value using cost of equity. Unlike the DCF where we find the enterprise value, DDM gives us the equity value. As an approximation, do you think it's OK to use EBITDA - Changes in Operating Assets and Liabilities - CapEx to approximate Unlevered Free Cash Flow? - answer-EBITDA ignores taxes all together. While it can work as a quick approximation, it would be better to consider: EBITDA - Changes in Operating Assets and Liabilities - CapEx - TAXES Can Beta ever be negative? What would that mean? - answer-Yes, in theory, a negative beta means that the company is a counter-cyclical one. When the economy is thriving, the business is struggling and vise versa. Compare cost of equity of firms in emerging and fast-growing geographies and markets to those in stable markets? - answer-cost of equity of firms in emerging and fast-growing geographies and markets will be higher Comparing smaller and bigger companies, who have a higher cost of equity? - answer-Smaller companies - more risky - higher 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 under CAPM? - answer-1) rE = rU + (rU-rd)BLev BLev = Bunlev*(1+(1-t)(1+D/E) Dividend yield is already considered in Beta. Beta describes the return in excess of the market, which includes the dividend yield. For unlevered free cash flows, what discount rate should we use? - answer-Wacc, because we care about all parts of the company's capital structure and we want to find the value to all investors How can you check whether your assumptions for Terminal Value using the Multiples Method vs. the Gordon Growth Method make sense? - answer-One way we can check if our assumptions for the terminal value is to calculate the terminal value using one method and then check what the implied long term growth rate is with the other method. For instance, with an How do we find the terminal value? - answer-Terminal Value = Final Year Free Cash Flow * (1 + Terminal FCF Growth Rate) / (Discount Rate - Terminal FCF Growth Rate). How do you calculate Beta in the Cost of Equity calculation? - answer-1) for a set of public comps, we need to find the levered beta for each company. Unlever it and find the mediam unlevered beta. Then we lever the unlevered based on the company's captial structure. How do you calculate WACC for a private company? - answer-Since private companies don't have market caps or betas, we would rely on the WACC down by auditors or estimate based on what the WACC is for similar public companies. How do you calculate WACC? - answer-WACC = Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1 - Tax Rate) + Cost of Preferred * (% Preferred) How do you determine a firm's Optimal Capital Structure? What does it mean? - answer-To maximize the value of the firm, we need to find a combination of capital structure that Min WACC. This will often be when the marginal benefit of the tax saving = to the marginal cost of bankruptcy or financial distress. The min wacc depends on the company, the industry, and the market. How do you know if a DCF is too dependent on future assumptions? - answer-There isn't one perfect rule, but if the terminal value accounts for over 90% of the company's value, then maybe the DCF is too depend on our future assumptions. How do you select the appropriate exit multiple when calculating Terminal Value? - answer-We can select the appropriate exit multiple by looking at public comps and picking the median of the set. We always want to show a range of the exit multiples and what the terminal value looks like over that range instead of picking 1 number. (Ex: if the median EBITDA multiple of the set is 8x, then we may want to show a range of 6x-10x) How do you treat Preferred Stock in the formulas above for Beta? - answer-Since preferred dividends are not tax-deductible, it is considered as equity. If a firm is losing money, do you still multiply the Cost of Debt by (1 - Tax Rate) in the WACC formula? How can a tax shield exist if they're not even paying taxes? - answer-In practice, we would still multiple it by (1-t). What is important is not if debt is currently giving the firm a tax-saving, but there is a possible potential for that to occur in the future. If I'm working with a public company in a DCF, how do I move from Enterprise Value to its Implied per Share Value? - answer-1) Find the equity value = Enterprise value + cash & cash equivalent - debt - preferred stock - noncontrolling interest 2) Find the per share price = Equity value / number of shares outstanding If we are using levered free cash flows, what discount rate should we use? - answer-we would use the cost of equity to find the value of the firm to the equity investors If you use Levered Free Cash Flow, what should you use as the Discount Rate? - answer-cost of equity Is there a valid reason why we might sometimes project 10 years or more anyway? - answer-If the company is a cyclical company. For instance, a biotech company. Then, we may want to project out the company father into the future to show the entire cycle from low to high free cash flow. Let's say that we assume 10% revenue growth and a 10% Discount Rate in a DCF analysis. Which change will have a bigger impact: reducing revenue growth to 9%, or reducing the Discount Rate to 9%? - answer-It could really go either way. The discount rate because the discount rate affects everything. Discount rate affects the present values of the terminal value and the FCF. Let's say that you use Levered Free Cash Flow rather than Unlevered Free Cash Flow in your DCF - what changes? - answer-Levered FCF: will give the equity value (only avaliable to equity investors) Unlevered FCF: give the enterprise value Let's say that you use Unlevered Free Cash Flow in a DCF to calculate Enterprise Value. Then, you work backwards and use the company's Cash, Debt, and so on to calculate its implied Equity Value. Then you run the analysis using Levered Free Cash Flow instead and calculate Equity Value at the end. Will the implied Equity Value from both these analyses by the same? - answer-Since it is challenging to pick equivalent assumptions for the two methods to get the same equity value, it will be very rare to get the same implied equity value. But if we could pick equivalent assumptions, we could in theory arrive at the same implied equity value. The reason why it is hard to pick equivalent assumptions is because for a levered DCF, the terms of debt impacts the FCF. This gives a different interest rate or repayment schedule that changes the equity value. Let's say we do this and find that the Implied per Share Value is $10.00. The company's current share price is $5.00. What does this mean? - answer-First, we need to look at a range of outputs from the DCF instead of 1 single number. If we find that the company's current share price is consistently lower than the Implied, then the company may be undervalued. Otherwise, the company may be overvalued. Let's take a look at companies during the financial crisis (or really, just any type of crisis or economic downturn). Does WACC increase or decrease? - answer-In a economic downtown, companies became less valuable. CFFA decrease CFFA = FCF / (1+wacc) So, investors would demand higher compensation for the higher risk. Increase wacc. Let's talk more about how you calculate Free Cash Flow. Is it always correct to leave out most of the Cash Flow from Investing section and all of the Cash Flow from Financing section? - answer-Most of time, it is correct to leave it out since expenses other than CapEx are commonly non-recurring in a predictable manner. B