5.5 - Valuation and DCF Analysis: How Different Factors Affect the DCF

OVERALL IMPACT AND KEY DRIVERS: Debt and Equity Levels What happens as a company uses more debt? Why?

As a company uses more Debt, its Cost of Debt and Cost of Equity will both increase. More debt makes the company riskier for everyone and increases the chance of bankruptcy, which would be bad for ALL investors

OVERALL IMPACT AND KEY DRIVERS: Beta Cost Equity? Debt? WACC? Implied Value from Unlevered DCF?

Beta works the same way as ERP Higher Beta increases the Cost of Equity and WACC and reduces the company's implied value Makes no impact on Cost of Debt A higher Beta just means more stock price volatility. If a company's Beta is 1.00, investors will expect this company stock price to increase by 10% when the market goes up by 10% However, if the Beta is 1.10, then with a 10% increase, investors will expect the stock price to increase by 11% Since the investors' expectations increases, the company's implied value to them decreases

OVERALL IMPACT AND KEY DRIVERS: Debt and Equity Levels What happens to WACC when debt increases?

Debt is cheaper than equity, so it will initially decrease WACC But after a certain point, the added risk from too much Debt starts to outweigh the cost benefits and you will see an increase in WACC

OVERALL IMPACT AND KEY DRIVERS: What makes the biggest impact on the DCF output? Why?

Discount Rate and Terminal Value Discount Rate affects EVERYTHING and because PV of the Terminal Value often represents over 50% of the company's implied value Also, because the Terminal Value make such a big impact, small changes to the Terminal FCF growth Rate or Terminal Multiples can also make a huge impact

OVERALL IMPACT AND KEY DRIVERS: Other Changes and Factors There are a lot of other possible factors that haven't been covered, but if you understand the concepts, you can reason your way through anything: What would happen to Additional Preferred Stock? Changes in interest rates on Debt? Changes in a company's FCF?

For example, if the company starts using additional Equity, that's the same as using less Debt, so all those changes would apply. Additional Preferred Stock is similar to additional Debt, but there's no tax benefit. So Cost of Equity will increase, and WACC will decrease initially and then start increasing. If the interest rate on Debt increases, the Cost of Debt will increase and WACC will also increase that higher rate doesn't affect the Cost of Equity. If a change increases the company's Free Cash Flow, the company's Implied Value will increase because the whole analysis is based on the Present Value of Free Cash Flows

` Equity Risk Premium What happens with higher ERP? Cost Equity? Debt? WACC? Implied Value from Unlevered DCF?

Higher ERP increases Cost of Equity and WACC because it means that the stock market is expected to return a higher percentage about the risk-free rate It WON'T make an impact on debt because debt investors earn fixed interest on their investments (stock market performance is irrelevant to them) An increase in ERP will decrease the implied value in a DCF

OVERALL IMPACT AND KEY DRIVERS: Risk-Free Rate What happens when the risk-free rate increases? Cost Equity? Debt? WACC? Implied Value from Unlevered DCF?

Higher risk free rate increases the Cost of Equity, Cost of Debt, and therefore increases WACC When government bonds start offering higher rates, investors will demand greater returns on corporate bonds, and stock market investors start demanding higher returns as well Higher risk-free rates represent better options elsewhere for ALL investors The company's implied value from DCF will decline

OVERALL IMPACT AND KEY DRIVERS: Tax Rate Cost Equity? Debt? Math behind it? WACC? Implied Value from Unlevered DCF?

Higher tax rate reduces the Cost of Debt because it increases the tax benefit of Debt Math: If the coupon rate is 10%, the Cost of Debt is 10% * (1 - 40%) = 6% at a 40% tax rate, but 10% * (1 - 50%) = 5% at a 50% tax rate Higher tax rate will also reduce the Cost of Equity because you use that tax rate when re-levering Beta: Re-Levered Beta = Unlevered Beta * (1 + Debt/Equity Ratio * (1 - Tax Rate)) Higher tax rates makes Debt less risky, which means that additional Debt is also less risky for Equity Investors.. So... WACC decreases with a higher tax rate (assuming the company has debt) It can be hard to determine the Implied Value from a DCF but it will usually DECREASE because a higher tax rate also reduces the company's FCF and that FCF reduction tends to make a bigger impact than the changes to the discount rate

OVERALL IMPACT AND KEY DRIVERS: Company Size and Geography Emerging Markets: Which is riskier? Growth potential? Cost Equity? Debt? WACC?

Similar to smaller companies, Tends to have greater risk, more growth potential, higher Cost of Equity and Debt, higher WACC, lower Implied Values from a DCF

OVERALL IMPACT AND KEY DRIVERS: Company Size and Geography Smaller or larger: Which is riskier? Growth potential? Cost Equity? Debt? WACC?

Smaller companies tends to have greater risk, more growth potential, higher Cost of Equity and Debt, higher WACC, lower Implied Values from a DCF

OVERALL IMPACT AND KEY DRIVERS: Debt and Equity Levels What happens when all debt is removed?

WACC will not change in a predictable way If there is too much debt, removing it all might be a decrease in WACC However, if there is an appropriate amount of debt, removing it completely could increase the WACC