Discounted Cash Flow Exam (Actual
2025/2026) Questions & Answers
| Latest Update | Certified Quality | Graded
A+
Walk me through a DCF ✔✔A DCF values a company based on the present value of its cash
flows and the present value of its terminal value. First, you projected out a company's financials
using assumptions for revenue growth, expenses, and working capital; then you get down to free
cash flow for each year, which you then sum up and discount back to a net present value, based
on your discount rate - usually the weighted average cost of capital. Once you have the present
value of the cash flows, you determine the company's terminal value, using either the multiples
method or the Gordon Growth method, and then also discount that back to its net present value
using WACC. Finally, you add the two together to determine the company's enterprise value
Walk me through how you get from revenue to free cash flow in the projections ✔✔Subtract
COGS and operating expenses to get to operating income (EBIT). Then multiple by (1-Tax
Rate), add back depreciation and other non-cash charges, and subtract Cap Ex and changes in
working capital
What's an alternate way to calculate Free Cash Flow aside from taking Net Income, adding back
Depreciation, and subtracting Changes in Operating Assets / Liabilities and CapEx? ✔✔Take
cash flow from operations and subtract CapEx - that gets you to levered cash flow. To get to
unlevered free cash flow, you then need to add back the tax-adjusted interest expense and
subtract the tax-adjusted interest income
Why do you use 5 or 10 years for DCF projections? ✔✔That's usually about as far as you can
reasonably predict into the future. Less than 5 years would be too short to be useful, and over 10
years is too difficult to predict for more companies
What do you normally use for the discount rate? ✔✔Normally you use WACC (weighted
average cost of capital), though you might also use cost of equity depending on how you've set
up the DCF
How do you calculate WACC? ✔✔The formula is cost of equity*(%Equity)+cost of
debt*(%Debt)(1-tax rate) + cost of preferred*(%Preferred). In all cases, the percentage refers to
how much of the company's capital structure is taken up by each component. For cost of equity,
you can use the capital asset pricing model and for the others you usually look at comparables
, companies /debt issuances and the interest rates and yields issues by similar companies to get
estimates
How do you calculate the cost of equity? ✔✔Cost of equity = risk-free rate+beta* equity risk
premium. The risk free rate represents how much a 10-year or 20-year U.S. treasury should
yield; Beta is calculated based on the "riskiness" of comparable companies and the equity risk
premium is the % by which stocks are expected to out-perform "risk-less" assets. Normally you
pull the equity risk premium from a publication called Ibbotson's
How do you get to beta in the cost of equity calculation? ✔✔You look up the Beta for each of
the comparable company, un-lever each one, take the median of the set and then lever it based on
your company's capital structure. You then use this levered beta in the cost of equity
calculations. For your reference, the formulas for un-levering and re-levering beta are below
Unlevered beta = levered beta / (1 + ((1-tax rate) x (total debt/equity))) Levered
beta = unlevered beta x (1+((1-tax rate)x(total debt/equity)))
Why do you have to un-lever and re-lever beta? ✔✔Again, keep in mind our "apples to apples"
theme. When you look up the Betas on Bloomberg they will be levered to reflect the debt already
assumed by each company. But each company's capital structure is different and we want to look
at how "risky" a company is regardless of what %debt or equity it has. To get that, we need to
unlever beta each time. But at the end of the calculation, we need to re-lever because we want the
Beta used in the cost of equity calculation to reflect the true risk of our company, taking into
account its capital structure at this time
Would you expect a manufacturing company or a technology company to have a higher Beta?
✔✔A technology company, because its technology is viewed as a "riskier" industry than
manufacturing
Let's say that you use Levered Free Cash Flow rather than Unlevered Free Cash Flow in your
DCF - what is the effect? ✔✔Levered free cash flow gives you equity value rather than
enterprise value, since the cash flow is only available to equity investors (debt investors have
already been "paid" with the interest payments)
If you use Levered Free Cash Flow, what should you use as the Discount Rate? ✔✔You would
use the cost of equity rather than WACC since we're not concerned with debt or preferred stock
in this case - we're calculating equity value, not enterprise value
How do you calculate the terminal value? ✔✔You can either apply an exit multiple to the
company's year 5 EBITDA, EBIT or free cash flow (multiples method) or you can use the
gordon growth method to estimate its value based on its growth rate into perpetuity. The formula
for terminal value using Gordon Growth is terminal value = year 5 free cash flow * (1+ growth
rate)/(discount rate - growth rate)
2025/2026) Questions & Answers
| Latest Update | Certified Quality | Graded
A+
Walk me through a DCF ✔✔A DCF values a company based on the present value of its cash
flows and the present value of its terminal value. First, you projected out a company's financials
using assumptions for revenue growth, expenses, and working capital; then you get down to free
cash flow for each year, which you then sum up and discount back to a net present value, based
on your discount rate - usually the weighted average cost of capital. Once you have the present
value of the cash flows, you determine the company's terminal value, using either the multiples
method or the Gordon Growth method, and then also discount that back to its net present value
using WACC. Finally, you add the two together to determine the company's enterprise value
Walk me through how you get from revenue to free cash flow in the projections ✔✔Subtract
COGS and operating expenses to get to operating income (EBIT). Then multiple by (1-Tax
Rate), add back depreciation and other non-cash charges, and subtract Cap Ex and changes in
working capital
What's an alternate way to calculate Free Cash Flow aside from taking Net Income, adding back
Depreciation, and subtracting Changes in Operating Assets / Liabilities and CapEx? ✔✔Take
cash flow from operations and subtract CapEx - that gets you to levered cash flow. To get to
unlevered free cash flow, you then need to add back the tax-adjusted interest expense and
subtract the tax-adjusted interest income
Why do you use 5 or 10 years for DCF projections? ✔✔That's usually about as far as you can
reasonably predict into the future. Less than 5 years would be too short to be useful, and over 10
years is too difficult to predict for more companies
What do you normally use for the discount rate? ✔✔Normally you use WACC (weighted
average cost of capital), though you might also use cost of equity depending on how you've set
up the DCF
How do you calculate WACC? ✔✔The formula is cost of equity*(%Equity)+cost of
debt*(%Debt)(1-tax rate) + cost of preferred*(%Preferred). In all cases, the percentage refers to
how much of the company's capital structure is taken up by each component. For cost of equity,
you can use the capital asset pricing model and for the others you usually look at comparables
, companies /debt issuances and the interest rates and yields issues by similar companies to get
estimates
How do you calculate the cost of equity? ✔✔Cost of equity = risk-free rate+beta* equity risk
premium. The risk free rate represents how much a 10-year or 20-year U.S. treasury should
yield; Beta is calculated based on the "riskiness" of comparable companies and the equity risk
premium is the % by which stocks are expected to out-perform "risk-less" assets. Normally you
pull the equity risk premium from a publication called Ibbotson's
How do you get to beta in the cost of equity calculation? ✔✔You look up the Beta for each of
the comparable company, un-lever each one, take the median of the set and then lever it based on
your company's capital structure. You then use this levered beta in the cost of equity
calculations. For your reference, the formulas for un-levering and re-levering beta are below
Unlevered beta = levered beta / (1 + ((1-tax rate) x (total debt/equity))) Levered
beta = unlevered beta x (1+((1-tax rate)x(total debt/equity)))
Why do you have to un-lever and re-lever beta? ✔✔Again, keep in mind our "apples to apples"
theme. When you look up the Betas on Bloomberg they will be levered to reflect the debt already
assumed by each company. But each company's capital structure is different and we want to look
at how "risky" a company is regardless of what %debt or equity it has. To get that, we need to
unlever beta each time. But at the end of the calculation, we need to re-lever because we want the
Beta used in the cost of equity calculation to reflect the true risk of our company, taking into
account its capital structure at this time
Would you expect a manufacturing company or a technology company to have a higher Beta?
✔✔A technology company, because its technology is viewed as a "riskier" industry than
manufacturing
Let's say that you use Levered Free Cash Flow rather than Unlevered Free Cash Flow in your
DCF - what is the effect? ✔✔Levered free cash flow gives you equity value rather than
enterprise value, since the cash flow is only available to equity investors (debt investors have
already been "paid" with the interest payments)
If you use Levered Free Cash Flow, what should you use as the Discount Rate? ✔✔You would
use the cost of equity rather than WACC since we're not concerned with debt or preferred stock
in this case - we're calculating equity value, not enterprise value
How do you calculate the terminal value? ✔✔You can either apply an exit multiple to the
company's year 5 EBITDA, EBIT or free cash flow (multiples method) or you can use the
gordon growth method to estimate its value based on its growth rate into perpetuity. The formula
for terminal value using Gordon Growth is terminal value = year 5 free cash flow * (1+ growth
rate)/(discount rate - growth rate)
