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Top 20 Interview Questions and Answers on DCF

Posted by : SHALINI SHARMA

1. What is DCF analysis?

Discounted Cash Flow (DCF) analysis is a technique for valuing a company, which looks at the present value of expected future free cash flows, discounted using the company's weighted average cost of capital (WACC). In essence, DCF uses projected future cash flows and then discounts them to present values to arrive at the company's intrinsic value. 

One of the methods for valuing a company, Discounted Cash Flow (DCF) analysis, considers the present value of future free cash flows that are expected to be generated by the company, discounted at the weighted average cost of capital (WACC). In other words, calculating the future cash flows as they enter the company and discount to the present would determine the intrinsic value for a company.

2. What are the main features of a DCF model?

The following are the essential features of a DCF model:

•Forecasted free cash flows for certain number of years.

•Discount rate (WACC) to be applied in discount future cash flows.

•Terminal value which takes into account the value beyond the forecasting period.

•Net debt to adjust for capital structure.

3. Why do you use WACC to discount cash flows?

The weighted average cost of capital, or WACC, is used to discount cash flows because it reflects the average rate of return that all investors - debt and equity holders - require from the organization. It takes into consideration the risk inherent in the business and its capital structure, rendering it the most appropriate discount rate for future cash flows.

4. What is the treatment of non-operating assets in DCF calculations?

The non-operating assets, including excess cash or investments, are generally added at the end of the DCF calculation to the enterprise value. They are not supposed to create operating cash flows but should be valued for the total value of the company. 

5. How Capital Expenditures Influence a DCF Model?

Capital expenditures (CapEx) represent long-term asset investments, and such expenditures may immediately reduce free cash flow but are vital to retain or increase the overall asset bases of the company. In a DCF, this expense is deducted when estimating FCFF.

6. What is the difference between net present value (NPV) and DCF?

Net Present Value is very often used with discounting future streams of cash, but it is a more general concept associated with present valuing any series of cash flows; in contrast, DCF specifically values a business by forecasting and discounting free cash flows. Therefore, in normal usage, DCF is a method of calculating NPV.

7. How does a DCF model really handle inflation?

The inflation reflection usually pertains to revenue growth as well as expense projections changing over time usually while modifying the discount rates (WACC) for inflation especially in cases where the cash flows are modeled in nominal terms.

8. What are the Common pitfalls in DCF analysis that investors face? 

•Cash flow projections that are overly optimistic or unrealistic in nature;

•Unreasonable assumptions about what the terminal value will account for;

•Misunderstanding in which way the WACC misrepresents the actual cost of equity; 

•Omitting shifts in working capital from calculations.

9. Why is it important to perform a sensitivity analysis in DCF? 

Sensitivity analysis helps in determining how key assumptions will affect the valuation of the desired asset (growth rate, WACC, terminal value). Since a DCF model is sensitive to assumptions, one understands what the possible outcomes of the prospective scenario are and thus tries to eliminate the risk of misevaluation by incorporating various assumptions.

10. What is the difference between the DCF and market comparable methods?

The DCF method discounts future cash flows projected for an enterprise and gives the value of a company. In contrast, the market comparable method uses peer firms, multiples such as P/E as well as other metrics like EV/EBITDA or EV/Sales, to value a company.

The former is an intrinsic value, and the latter reflects how the market believes it values comparable firms.

11. How do you account for changes in debt when forecasting free cash flows in a DCF?

In a DCF analysis, changes in debt are accounted for solely as they affect free cash flows in forecasting Free Cash Flow to Firm (FCFF). Changes in debt are generally not considered in the FCFF forecast, as FCFF is cash flow in relation to all providers of capital, not just equity holders. However, changes in net debt incurred or repaid under the Free Cash Flow to Equity (FCFE) formula provide an important consideration with regard to free cash flow to equity funds. Reflected in the financing activities section, debt adjustment should be considered.

12. What is the difference between nominal and real terms in a DCF model?

Nominal terms, in such a DCF model, refer to cash flows and discount rates that, in effect, include the appropriateness of inflation. On the other hand, real terms indicate cash flows and discount rates without inflation. Cash-flows in real terms should then have a discount rate devoid of inflation; this ensures that both cash flows and discount rates are consistent.

13. How will you fit a DCF to a fluctuating Capex firm?

To forecast CAPEX for a company with fluctuating capital expenditures in the DCF process, it usually entails forecasting it year by year in accordance with the future investment strategy and plans of the company. Historical averages or a percentage of revenues are often applied in the forecasting exercise. Once all fluctuations have been catered-for, free cash flow projection would include the effect that such fluctuations would have on the company's cash-generating ability after reinvestments in its capital assets.

14. What is depreciation in DCF model?

Depreciation is a non-cash expense. It reduces net income, but it has no impact on cash flow directly. However, when calculating Free Cash Flow to the Firm (FCFF) in a DCF model, depreciation is added back to the cash flows as there isn't a cash outflow associated with that. It reduces taxable income and thus provides a tax shield effect-this "indirectly" impacts free cash flows.

15. How would you convert a company with an erratic cash flow into a DCF model?

After the forecasted free cash flows for periods of volatility and then perform sensitivity analysis on varying assumptions. A more conservative long-term growth rate or a relevant multiple might be adopted for the terminal value as per the inherent risk and stability of the business.

16. In what ways is a long-term growth rate important while doing a DCF model?

To evaluate the firm in future, this long-term growth rate becomes important because it assumes that free cash flows will continue to grow at that rate into perpetuity after the forecasting period. An insignificant change in the long-term growth rate changes the terminal value drastically. This, in turn, alters the value altogether. Establish realistic growth rates, relative to the industry and other economic conditions, while making this assumption.

17. How do you perform a DCF adjustment to a business with segments?

As it applies to the business unit segmentation, a segment defined in relation to business lines must have its financial characteristics evaluated with respect to revenue growth assumptions, margins, capital expenditures, and risk profiles, together at the end with cash flows for the segment. After separating the cash flows, they can be brought together late in the analysis through appropriate weights or adjustments for internal or segment interdependencies.

18. What is a "hockey stick" projection and how does it impact DCF analyses?

By "hockey stick" projections we mean rather excessively rosy cash flow forecasts, indicating only small amounts of early growth, followed by steep slopes of great increase, often without justification in sales or underlying fundamentals. In a DCF, such projections create chances for a difference between value and eventual actual experience. It is advisable to ensure that projections are based on realistic assumptions and to apply sensitivity analysis to the outcomes for any possible overestimations.

19. How do you account for a company’s debt in a DCF valuation?

Essentially, debt consideration includes the following while deriving the company's enterprise value in DCF analysis. When FCFF is being used, cash flows would not be considered in debt repayment since both debt and equity holders can access them. In the case of FCFE, debt payments (or issuances) are added to or subtracted from free cash flow concerning what is available for equity holders after debt servicing.

20. What is the role of taxes in a DCF analysis?

In a DCF, taxes generally lower the effective cash flow an entity retains post taxation. Tax adjustments apply both in the calculation of FCFF and FCFE. In FCFF, tax charge is computed from EBIT, while in FCFE, tax impact is factored into net income. Tax rate is also considered in cash flow forecast and WACC.