DCF Practice Questions part 1 (approaches to valuation)

Question 1 - DCF Valuation Fundamentals: Discounted cash flow valuation is based upon the notion that the value of an asset is the present value of the expected cash flows on that asset, discounted at a rate that reflects the riskiness of those cash flows. Specify whether the following statements about discounted cash flow valuation are true or false, assuming that all variables are constant except for the variable discussed below: As the uncertainty about the expected cash flows increases, the value of an asset increases.

False. Generally, the greater the uncertainty, the lower is the value of an asset.

Question 5 - Relative Valuation: Fundamentals An analyst tells you that he uses price/earnings multiples, rather than discounted cash flow valuation, to value stocks, because he does not like making assumptions about fundamentals - growth, risk, and payout ratios. Is his reasoning correct?

No. Any time a multiple is used, there is implicit, in that multiple, assumptions about growth, risk and payout. In fact, any multiple can be stated as an explicit function of these variables.

Question 4 - Problems in DCF Valuation Why might discounted cash flow valuation be difficult to do for the following types of firms? Why might discounted cash flow valuation be difficult to do for the following types of firms? A biotechnology firm, with no current products or sales, but with several promising product patents in the pipeline.

Since the firm has no history of earnings and cash flow growth and, in fact, no potential for either in the near future, estimating near term cash flows may be impossible.

Question 6 - Industry Average P/E Ratios (look at image)

A. Average P/E Ratio = 31.98 B. No. Eliminate the outliers, because they are likely to skew the average. The average P/E ratio without GET and King World is 25.16. C. You are assuming that (1) Paramount is similar to the average firm in the industry in terms of growth and risk. (2) The marker is valuing communications firms correctly, on average.

Question 3 - Mismatching Cash flows and Discount Rates The following are the projected cash flows to equity and to the firm over the next five years: Look at image

A. PV of CF to Equity = 250/1.12 + 262.50/1.12^2 + 275.63/1.12^3 + 289.41/1.12^4 + (303.88+3946.50)/1.12^5 = $3224 B. PV of CF to Firm = 340/1.0994 + 357/1.0994^2 + 374.85/1.0994^3 + 393.59/1.0994^4 + (413.27+6000)/1.0994^5 = $5149

Question 1 - DCF Valuation Fundamentals: Discounted cash flow valuation is based upon the notion that the value of an asset is the present value of the expected cash flows on that asset, discounted at a rate that reflects the riskiness of those cash flows. Specify whether the following statements about discounted cash flow valuation are true or false, assuming that all variables are constant except for the variable discussed below: An asset with an infinite life (i.e., it is expected to last forever) will have an infinite value.

False. The present value effect will translate the value of an asset from infinite to finite terms.

Question 1 - DCF Valuation Fundamentals: Discounted cash flow valuation is based upon the notion that the value of an asset is the present value of the expected cash flows on that asset, discounted at a rate that reflects the riskiness of those cash flows. Specify whether the following statements about discounted cash flow valuation are true or false, assuming that all variables are constant except for the variable discussed below: As the discount rate increases, the value of an asset increases.

False. The reverse is generally true.

Question 4 - Problems in DCF Valuation Why might discounted cash flow valuation be difficult to do for the following types of firms? Why might discounted cash flow valuation be difficult to do for the following types of firms? A. A private firm, where the owner is planning to sell the firm.

It might be difficult to estimate how much of the success of the private firm is due to the owner's special skills and contacts.

Question 4 - Problems in DCF Valuation Why might discounted cash flow valuation be difficult to do for the following types of firms? Why might discounted cash flow valuation be difficult to do for the following types of firms? A firm, which is in the process of restructuring, where it is selling some of its assets and changing its financial mix.

Restructuring alters the asset and liability mix of the firm, making it difficult to use historical data on earnings growth and cash flows on the firm.

Question 4 - Problems in DCF Valuation Why might discounted cash flow valuation be difficult to do for the following types of firms? Why might discounted cash flow valuation be difficult to do for the following types of firms? A troubled firm, which has made significant losses and is not expected to get out of trouble for a few years.

Since discounted cash flow valuation requires positive cash flows sometime in the near term, valuing troubled firms, which are likely to have negative cash flows in the foreseeable future, is likely to be difficult.

Question 4 - Problems in DCF Valuation Why might discounted cash flow valuation be difficult to do for the following types of firms? Why might discounted cash flow valuation be difficult to do for the following types of firms? A cyclical firm, during a recession.

The firm's current earnings and cash flows may be depressed due to the recession. Other measures, such as debt-equity ratios and return on assets may also be affected.

Question 1 - DCF Valuation Fundamentals: Discounted cash flow valuation is based upon the notion that the value of an asset is the present value of the expected cash flows on that asset, discounted at a rate that reflects the riskiness of those cash flows. Specify whether the following statements about discounted cash flow valuation are true or false, assuming that all variables are constant except for the variable discussed below: As the expected growth rate in cash flows increases, the value of an asset increases.

True. The value of an asset is an increasing function of its cash flows.

Question 1 - DCF Valuation Fundamentals: Discounted cash flow valuation is based upon the notion that the value of an asset is the present value of the expected cash flows on that asset, discounted at a rate that reflects the riskiness of those cash flows. Specify whether the following statements about discounted cash flow valuation are true or false, assuming that all variables are constant except for the variable discussed below: As the life of an asset is lengthened, the value of that asset increases.

True. The value of an asset is an increasing function of its life.

Question 4 - Problems in DCF Valuation Why might discounted cash flow valuation be difficult to do for the following types of firms? A firm, which owns a lot of valuable land that is currently unutilized.

Unutilized assets do not produce cash flows and hence do not show up in discounted cash flow valuation, unless they are considered separately.

Question 2 - Approaches to DCF Valuation There are two approaches to valuation. The first approach is to value the equity in the firm. The second approach is to value the entire firm. What is the distinction? Why does it matter?

When equity is valued, the cash flows to equity investors are discounted at their cost (the cost of equity) to arrive at a present value, which is the value of the equity stake in the business. When the firm is valued, the cash flows to all investors in the firm (including equity investors, lenders and preferred stockholders) are discounted at the weighted average cost of capital to arrive at a present value, which equals the value of the entire firm (generally much higher than the value of just the equity stake.) The distinction matters for two reasons: (1) Mismatching cash flows and discount rates can cause significant errors in valuation. (2) Not recognizing what the present value of the cash flows measures can also lead to misinterpretations. For instance, if the present value of cash flows to the firm is treated as the value of equity, there is an obvious problem.