IB-Discounted Cash Flow Questions

How to calculate cost of equity?

Cost of equity = Risk-Free Rate + Beta * Equity Risk Premium

What is Beta?

Beta is a measure of the volatility of an investment compared with the market as a whole. The market has a beta of 1, while investments that are more volatile than the market have a beta greater than 1 and those that are less volatile have a beta of less than 1. High-beta stocks are supposed to be riskier but provide higher return potential; low-beta stocks pose less risk but also lower returns.

How to calculate Beta?

Beta is calculated using regression analysis. Numerically, it represents the tendency for a security's returns to respond to swings in the market. The formula for calculating beta is the covariance of the return of an asset with the return of the benchmark divided by the variance of the return of the benchmark over a certain period.

Why would you not use a DCF for a bank or other financial institution?

-banks use debt differently than other companies and do not re-invest it in the business they use it to create products instead. Interest is an important part of bank's business models and working capital takes up a huge part of their balance sheets more common to use a dividen discount model

Which method of calculating Terminal Value will give you a higher valuation?

-both are dependent on the assumptions you make -in general, Multiples Method will be more variable than the GGM because exit multiples tend to pan a wider range

Will WACC be higher for a $5 billion or $500 million company?

-depends on whether cap structure is the same for both companies -if the cap structure is the same with % and interest rates, the WACC will be higher for the 500 million company

What has a greater impact on a company's DCF valuation - a 10% change in revenue or a 1% change in the discount rate?

-it depends but usually a 10% difference in revenue has more impact the change will affect Revenue/EBITDa far into the future

What type of sensitivity analyses would we look at in a DCF?

1. revenue Growth vs. Terminal multiple 2. EBITDA margin vs. terminal multiple 3. terminal multiple vs. discount rate 4. long-term growth rate vs. discount rate

How would you calculate WACC for a private company?

-problematic bc private companies don't have market caps or betas -most likely estimate WACC based on work done by auditors or valuation specialists or WACCs for comparable public companies

What's the flaw with basing terminal multiples on what public company comparables are trading at?

-the median multiple may change greatly in the next 5-10 years

Why do you use 5-10 years for DCF projections?

-usually as far as you can reasonably predict

How to calculate terminal value?

1. Multiples Method - apply existing multiple to company's year 5 EBITDA, EBIT, or Free Cash Flow 2. Gordon Growth Model

How to get to Beta in the Cost of Equity Calculation?

1. find Beta for each comparable company, unlever each one, take the media of the set, and lever it based on company's capital structure Unlevered Beta = Levered Beta / (1+((1-Tax Rate)*(Total Debt/Equity))) Levered Beta = Un-Levered beta x (1+((1-Tax Rate)*(Total Debt/Equity)

How do you get from revenue to FCF in the DCF projections?

1. subtract COGS and operating expenses to get to Operating income (EBIT) 2. Multiply EBIT by (1-t) 3. Add depreciation + other non-cash expenses 4. subtract capex and change in working capital 5. this gives you unlevered free cash flows (available to all investors because it does not subtract interests)

Cost of Equity formula

=risk-free Rate + Beta * Equity risk premium

Would you expect a manufacturing company or a technology company to have a higher Beta?

A technology company, because tech is viewed as riskier industry than manufacturing

How to calculate cost of equity without CAPM?

Alternate formula: Re=(Dividends per Share/Share price) + growth rate of dividends

Gordon Growth Model formula

GGM = Terminal Value = Year 5 free Cash Flow * (1+g)/Discount rate -g)

How to know if DCF is too dependent on future assumptions?

If significantly more than 50% of company's EV comes from TV, DCF is too dependent. in reality, almost all DCF's are too dependent on future assumptions.

What is the effect of using levered free cash flows vs. unlevered free cash flows in a DCF?

Levered cash flows give equity value rather than the enterprise value since the cash flow is only available to equity investors.

What's the relationship between debt and Cost of Equity?

More debt means that the compay is more risky, so the company's levered Beta will be higher

When you're calculating WACC, let's say that the company has convertible debt. Do you count this as debt when calculating Levered Beta for the company?

Trick Question: if the convertible debt is in the money, then you do not count it as debt but instead assume that it contributes to dilution so the company's Equity Value is higher. if its out of the money, then you count it as debt and use the interest rate on the convertible for Cost of Debt

Should we factor dividend yield into CAPM?

Trick question: dividend yields are already factored into beta, bc beta describes returns in excess of the market as a whole - and those returns include dividends.

How to calculate WACC?

WACC= Cost of Equity * (%Equity) + Cost of Debt * (% Debt) *(1-tax) + Cost of Preferred*(%preferred)

Why do you have to unlever and re-lever Beta?

When you look up Betas, they will be levered to reflect the debt assumed by a company. But each company's capital structure is different and we want to look at how risk a company is regardless of what % of debt or equity it has. But at the end, we need to re-lever the beta because we want the Beta used in the cost of equity calculation to reflect the true risk of the company, taking into account its capital structure.

What is CAPM (Capital Asset Pricing Model)

a model based on the proposition that any stock's required rate of return is equal to the risk-free rate of return plus a risk premium that reflects only the risk remaining after diversification

What's an appropriate growth rate to use when calculating the Terminal Value?

country's long-term GDP growth rate, the rate of inflation, or something similarly conservative. In mature economies, a long-term growth rate over 5% is aggressive.

Why use GGM rather than Multiples Method?

in banking, almost always use multiples method. Its much easier to get exit multipled since they are based on comparable companies. Use GGM is there are no good comparable companies or if you have reason to believe that multiples will change significantly down the road.

Should Cost of Equity be higher for a $5 billion or $500 million market cap company?

it should be higher for the 500 million company bc all else equal, smaller companies are expected to outperform large companies in the stock market (and therefore be more risky) using a size premium will ensure the cost of equity is higher for the 500 million company

What has greater impact - a 1% change in revenue or 1% change in discount rate

the discount rate usually

2 companies are exactly the same but one has debt and one does not - which one will have the higher WACC?

the one without debt will have a higher WACC up to a certain point bc debt is less expensive than equity 1. interest on debt is tax deductible 2. Debt is senior to equity in a company's cap structure 3. Interest rates on debt are lower than the Cost of Equity, so cost of Debt portion of WACC is less than the cost of equity portion however...

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?

trick question: you don't account for this at all in a DCF bc paying off debt principal shows up in Cash Flow from financing on the Cash Flow Statement - but we only go to cash flow from operations and subtract cap ex to get FCF if we were looking at LFCF, then interest expense would decline in future years due to the principle being paid off - but we still wouldn't count the principal repayments themselves anywhere