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Top 20 Investment banking Questions and Answers on Discounted Cash Flow
Posted by : SHALINI SHARMA
1. Walk me through a DCF ?
A DCF analysis starts withprojecting a company's financials, making assumptions about revenue growth,expenses, and working capital. From this, one calculates Free Cash Flow foreach year and sums these up and then discounts to its present value by using adiscount rate (usually WACC).
Once you have determined thepresent value of cash flows, you compute the company's Terminal Value. You caneither use the Multiples Method or the Gordon Growth Method, and you thendiscount that Terminal Value to its present value by applying the same WACC.
Lastly, you add together thepresent value of cash flows and the present value of the Terminal Value to findthe Enterprise Value of the company.
2. How do you get from Revenueto Free Cash Flow in projections?
First, subtract the Cost of GoodsSold (COGS) and Operating Expenses from revenue to get to Operating Income,known as EBIT. Then multiply by (1 - Tax Rate) to get after tax operatingincome. Then, add back non-cash items such as Depreciation and subtract CapExand changes in Working Capital.
This calculation gives youUnlevered Free Cash Flow, assuming you're starting with EBIT instead of EBT.
3. Alternate way to calculateFree Cash Flow?
Another method is to take CashFlow From Operations (CFO), subtract CapEx, and then account for mandatory debtrepayments. This results in Levered Free Cash Flow. To convert to UnleveredFree Cash Flow, you need to add back the tax-adjusted interest expense andsubtract any tax-adjusted interest income.
4. Why use 5 or 10 years forDCF projections?
5 to 10 years is generally theideal range for projecting future financials, as it is far enough out tocapture significant growth, but not so far that the projections become toospeculative.
5. What discount rate do youtypically use?
You would typically use WACC asthe discount rate, but sometimes you'll use Cost of Equity depending on thedetails of the DCF.
6. How do you calculate WACC?
WACC is calculated using thisformula:
WACC = (Cost of Equity * %Equity) + (Cost of Debt * % Debt * (1 - Tax Rate)) + (Cost of Preferred * %Preferred).
The percentages are the company'scapital structure.
CAPM may be applied in order toobtain the Cost of Equity. Normally, to calculate Cost of Debt and Cost ofPreferred, one compares to similar companies or debt issuance.
7. How would you find the Costof Equity?
The formula to determine Cost ofEquity is given below:
Cost of Equity = Risk-Free Rate +Beta * Equity Risk Premium.
The Risk-Free Rate is typicallyderived from 10- or 20-year US Treasury yields. Beta measures the stock'svolatility relative to the market, and the Equity Risk Premium is the expectedexcess return of stocks over risk-free assets. This data often comes frompublications like Ibbotson's.
You may also add a "sizepremium" or "industry premium" to account for small companystocks or specific industry risk in some cases.
8. How do you get to Beta inthe Cost of Equity calculation?
You start by finding the Betas ofcomparable companies (typically available on Bloomberg), de-lever each of thoseBetas, and then average the set. Then that average is re-levered based on thecompany's capital structure. The de-levering and re-levering formula for Betaare:
Un-Levered Beta = Levered Beta /(1 + ((1 - Tax Rate) * (Debt/Equity)))
Levered Beta = Un-Levered Beta *(1 + ((1 - Tax Rate) * (Debt/Equity)))
9. Why un-lever and re-lever Beta?
Beta for comparable companies istypically levered to reflect its existing debt. Your firm capital may bedifferent, so, when beta is un-levered, then re-levered this yields a moreaccurate reflection of your risks.
10. Which of the two companieswould have a higher Beta, a manufacturing or a technology company?
A technology company would have ahigher Beta because technology is perceived as a more volatile and"riskier" industry than manufacturing.
11. What is the impact of usingLevered Free Cash Flow in a DCF?
Using Levered Free Cash Flowyields an Equity Value rather than an Enterprise Value. It is because LeveredFree Cash Flow is after paying interest on debt, thus representing only thecash flow that's available to equity investors.
12. What discount rate wouldyou apply when using Levered Free Cash Flow?
With Levered Free Cash Flow, thediscount rate should be the Cost of Equity, not WACC. Since the cash flow isavailable only to equity investors, there's no need to account for debt orpreferred stock.
13. How do you calculate theTerminal Value?
You can calculate the TerminalValue in two ways:
Multiples Method: Apply an exitmultiple to the company's Year 5 EBITDA, EBIT, or Free Cash Flow.
Gordon Growth Method: Use theformula:
Terminal Value = Year 5 Free CashFlow * (1 + Growth Rate) / (Discount Rate - Growth Rate).
14. Why use the Gordon GrowthMethod for Terminal Value?
The Multiples Method is morecommonly used, given its basis on information from Comparable Companies. TheGordon Growth Method can be employed if there is no adequate comparable or inindustries where multiples are likely to change meaningfully in the future,particularly in cyclic industries.
15. What is a reasonable growthrate to assume for Terminal Value?
Ideally, growth should beconservative, at around long-term GDP growth rate or inflation rate, typicallybelow 5% for companies in developed economies.
16. How do you select the rightexit multiple?
Typically, you'd select an exitmultiple based on Comparable Companies and then use the median multiple.However, it is always prudent to use a range of exit multiples for youranalysis rather than using one number due to the presence of variability.
17. Which Terminal Value methodgenerally results in the greater value?
Hard to say; it just depends onassumptions. The Multiples method can be a bit noisier because exit multiplestend to have a higher distribution than long-term growth rates.
18. What's wrong with usingpublic company comparables for Terminal Multiples?
The multiples for comparablecompanies can change over time, so the exit multiples used today may beincorrect in the future. This is especially problematic for cyclicalindustries, such as semiconductors.
19. How do you know if your DCFrelies too heavily on future assumptions?
If a significant portion of theEnterprise Value (over 50%) is derived from the Terminal Value, the DCF may beoverly dependent on future assumptions. In practice, it’s common for TerminalValue to account for a large portion (sometimes 80-90%) of the valuation, soit’s important to check the assumptions.
20. Should the Cost of Equitybe higher for a $5 billion or $500 million market cap company?
The Cost of Equity should behigher for the $500 million company because smaller companies are consideredriskier and are expected to outperform larger companies. This higher risk isreflected in the cost of equity, often adjusted with a "size premium."
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