DCF Quiz Basic
22. You are calculating the Terminal Value of a high-growth technology company in a DCF, and the company has $0 in Operating Income (EBIT) from Year 1 a. b. c. d. e. f. to Year 5. How do you calculate Terminal Value? Terminal Multiple Method: Enterprise Value / EBIT Terminal Multiple Method: Enterprise Value / Revenue Terminal Multiple Method: Equity Value / Net Income Gordon Growth Method: Estimate long-term FCF growth Terminal Multiple Method: Enterprise Value / Unlevered FCF Question is misleading - you should not be using a DCF at all for this scenario
Explanation: A DCF only makes sense if the company is profitable and has relatively stable, predictable cash flows. A DCF is least applicable to a high-growth company with minimal profits, and in a scenario like this it is relatively useless for valuation purposes. If you projected it out 10-20 years into the future and the company actually had positive EBIT or cash flow by them, it might make more sense to use Terminal Value and stick with the DCF analysis. But otherwise, none of these answers is correct because the premise of the question is flawed in the first place.
14. Which of the following inputs is NOT required to calculate Cost of Equity for a company in the conventional way (i.e. by using the Capital Asset Pricing Model)? a. Expected yield on a 20-year US (or other government) Treasury Bond b. Beta of the company's stock (historical or estimated) c. The difference between expected returns in the relevant stock market index (e.g. the S&P 500 or the FTSE 100 in Europe) and a "risk-free" Treasury Bond d. None of the above - you need all of them to calculate Cost of Equity
Explanation: According to CAPM, Cost of Equity = Risk-free rate + Equity Risk Premium * Beta. Answer choice A is a proxy for the risk-free rate part of the formula (note: it doesn't have to be a 20 year Treasury...it could easily be a 10 year Treasury or something else - this tends to be bank specific and group specific). You also need Beta to measure the riskiness and expected returns of the stock relative to the rest of the market, and you need C (the Equity Risk Premium) to determine how much, on average, companies may return over risk-free securities (which you then adjust using Beta).
2. Which of the following steps do you complete in a DCF analysis? a. Project cash flows in the "near future" period b. Project cash flows in the "far future" period c. Determine the appropriate discount rate to discount cash flows by d. Add together all the discounted cash flows to determine the NPV
Explanation: All of the above entail the steps necessary in completing a DCF analysis. As mentioned before, the value of the company consists of two components: 'near future' period cash flows and 'far future' period cash flows. For the former we can project these cash flows within a 5 to 10 year period. For the latter, we need to approximate these cash flows by estimating the Terminal Value. Once both 'near future' and 'far future' cash flows are estimated, we calculate the appropriate discount rate to determine their present values. Finally, once everything is discounted to present value we add together the two figures to obtain Enterprise (or Equity) value, depending on which type of FCF we projected.
3. How Cash Flow analysis? is a Dividend Discount Model different from a conventional Discounted a. Dividends are discounted instead of Free Cash Flow b. Cost of Equity is used as the discount rate instead of WACC c. Terminal Value is based on a P / BV or P / E multiple instead of EV/EBITDA d. None of the above
Explanation: All of the statements above are correct differences when doing a DDM instead of a DCF. Answer choice A is correct as dividends are used in place of Free Cash Flow (dividends are assumed to be a proxy for FCF for some types of companies, such as banks and insurance firms). Answer choice B is correct because in a DDM we only discount cash flows at Cost of Equity, NOT the overall WACC - since dividends only go to equity investors, we're calculating Equity Value and using Cost of Equity. Answer choice C is correct because we want to use an Equity Value-based multiple, such as P / E or P / BV, as opposed to an Enterprise Value-based multiple when using a DDM.
9. When calculating Unlevered Free Cash Flow (Free Cash Flow to Firm), all of the following are "Non-Cash Charges" that need to be added back to EBIT * (1 - Tax Rate) EXCEPT: a. Depreciation & Amortization (D&A) b. Stock-Based Compensation (SBC) c. Goodwill Impairment Charges d. Non-Cash Restructuring Charges e. All of the charges above should be added back
Explanation: All of these constitute non-cash charges. D&A and SBC are the most common ones that you see with 99% of all companies, but Goodwill Impairment is another common non- cash charge - it represents a write-down of Goodwill on the Balance Sheet, but is not an actual cash loss. Many Restructuring Charges are also classified as non-cash, and they have the same impact as everything else here: they save the company on taxes, but the actual expense does not cost the company anything.
16. Which of the following formulas represent CORRECT methods for calculating Cost of Equity? a. Risk-Free Rate + Equity Risk Premium * Beta b. (Earnings per Share / Share Price) + Growth Rate of EPS c. (Dividends per Share / Share Price) + Growth Rate of Dividends d. Calculate the Capitalized Annual Growth Rate (CAGR) of the company's annual return, including dividends, over the past 5-10 years
Explanation: Answer choice A is correct as that is the traditional 'Capital Asset Pricing Model' (aka CAPM) formula used for Cost of Equity. Answer choice B is incorrect, as the alternative method of calculating Cost of Equity does not deal with EPS figures or growth rates. The other correct answer choice here is C. Note the first part of the formula - Dividends per Share / Share Price - is also referred to as 'dividend yield'. This should make sense as the "expense" of issuing stock is the dividend it pays (as a percentage of share price) plus the expected growth rate in that dividend payment. While D is an interesting idea, in practice you never use such a formula or technique to calculate Cost of Equity.
34. Now let's extend this same scenario. Which company would MOST likely have the higher Terminal Value in a DCF analysis under the same conditions? a. Company A b. Company B c. Can't tell without additional information d. Both would have the same Terminal Value since the total FCFs for each one are the same
Explanation: B is correct because its Free Cash Flow will be significantly higher than A's FCF in Year 5, if Company A generates less than 10% of its total FCF in that final year. So this is the other side to a scenario like this: yes, the NPV of Free Cash Flows is higher if they arrive earlier on in higher numbers, but the Terminal Value is likely to be much lower if they decline in future years. And, in turn, that means that Company B is likely to be worth a lot more than Company A in this analysis since the Terminal Value comprises the majority of value in most DCF analyses. C is incorrect because we have all the information we need, and D is incorrect because Terminal Value is dependent on the final year FCF, not the total FCFs generated in the 5-year projection period.
24. When using the Terminal Multiple method to determine Terminal Value, how should you determine the appropriate range of multiples to use in the analysis? a. Base it on the range of multiples for the Public Comps b. Base it on the range of multiples for the Precedent Transactions c. Base it on the range of multiples for the Public Comps, but use slightly lower multiples to account for the fact that multiples decline over time d. You should come up with reasonable long-term growth rate assumptions first, use the Gordon Growth Method, and then work backwards to come up with the equivalent multiples.
Explanation: B is incorrect because multiples tend to be higher- than-normal for Precedent Transactions since buyers must pay a control premium when acquiring sellers, and in a DCF analysis we want to be as conservative as possible. A is the right idea, but we want to be even more conservative than that to account for the fact that valuation multiples will decline into the future as companies grow and earn higher revenue and EBITDA, so C is the best option here. D is not "wrong," but you would use the method in D if you already have the Terminal Value via the Gordon Growth method and you want to double-check your work by seeing what the implied valuation multiples are.
18. Company A is in a non-cyclical industry and is financed with 100% equity. Company B is in a highly cyclical industry and is financed with 40% debt and 60% equity in its capital structure. Which company would you expect to have a higher Beta, Company A or Company B? a. Company A b. Company B c. Both should have about the same Beta, because the extra risk introduced by 100% equity will be canceled out by the fact that Company A is in a non-cyclical industry d. You need additional information to answer the question
Explanation: Cyclicality will always increase Beta because it makes the stock's performance vary more than the performance of the market as a whole. Debt will also always increase Beta because a company with Debt is riskier than one without Debt due to the possibility of defaulting. So Company B should have a higher Beta. The statement in answer choice C sounds tempting, but it is untrue because a 100% equity capital structure does not introduce "extra risk." And D is false because you already have enough information to make an educated guess.
21. You are valuing ACME Co., a highly cyclical basic materials manufacturer. You have calculated the Unlevered Free Cash Flows for the next five years. Now you need to calculate the Terminal Value. Currently the sector is in an "expansion" phase where valuations tend to be higher, but in 6 years you expect the market to reverse and enter the "contraction" phase of the cycle. Which method should you use to calculate ACME Co.'s Terminal Value? a. Terminal Multiple Method b. Gordon Growth Method c. Either method would produce the same results d. You need to see the median multiples the comps are trading at first
Explanation: In practice, most bankers use the Exit Multiple method to calculate Terminal Value. However, ACME Co. is in a highly cyclical sector (i.e. basic materials) and the question states that beyond year 5 of cash flows projected, the cycle affecting basic materials is expect to completely reverse itself. In this case, it would not make sense to apply an exit multiple because it would be based on current market conditions, which would not hold up once Year 6 comes around. So in this case, it is better to base the company's value on its expected FCF growth far into the future (Gordon Growth) than on the current market multiples.
27. You've calculated the present value of Terminal Value and the present value of Free Cash Flows in a DCF. Which of the following values would be LEAST likely for the Present Value of Terminal Value as a percentage of Enterprise Value? a. 10% b. 75% c. 50% d. 90%
Explanation: Most often in a DCF analysis, the present value of the Terminal Value comprises a huge percentage of the company's implied Enterprise Value. Percentages of up to 75% and even beyond that, up to 90%, are not unusual. In fact, sometimes bankers go back and modify assumptions if the value there is too high. 10% would be very unusual and the least likely outcome here, because effectively it's saying that 90% of a company's value comes from the next 5 years, but only 10% of its value comes from Year 6 into infinity - which doesn't make intuitive sense. This percentage is almost always at least 50%, and sometimes much higher than that.
13. What does the "Cost of Equity" really mean? What does it actually "cost" a company to issue equity to investors if there's no interest expense or principal repayment? a. Dividend payments b. After-tax dividend payments c. Giving up a percentage ownership in the company to 3rd party investors d. Giving up potential stock price appreciation to 3rd party investors e. None of the above
Explanation: One explicit "Cost" of Equity is the dividend payments that a company may be required to make after issuing equity, if its policy is to issue dividends. Note that unlike interest expense, dividend payments are NOT tax deductible, and as a result answer choice B is incorrect. Aside from explicit dividends, issuing equity also has the opportunity cost of giving up future stock price appreciation to others rather than keeping it for the company itself. As a result, both A and D are correct answer choices. C is incorrect because giving up percentage ownership in the company is not a true "cost" in the same way as the opportunity cost of giving up stock price appreciation. It just means that existing shareholders will have less say in the company's affairs.
12. A company's capital structure consists of 100% equity, with no Debt or Preferred Stock outstanding. What is its WACC? a. Cost of Equity b. Impossible to say without knowing the company's share price c. Close to, but not exactly equal to Cost of Equity since future debt or Preferred Stock issuances may affect it d. It depends on the direction that interest rates are heading in the overall economy
Explanation: Plug the numbers into the formula yourself and see: when debt and Preferred Stock do not exist, WACC = Cost of Equity because nothing else is there in the capital structure. B is incorrect because share price has nothing to do with it; C is incorrect because you only take into account future changes if you know in advance what those changes will be. D is completely wrong because future interest rates do not impact WACC at all.
23. ACME Co. is based in the US or another developed country with a long-term GDP growth rate of 2-3%. Historically, ACME Co. has grown its Free Cash Flow year-over-year by over 10%. You have projected the Free Cash Flows for the next 5 years and are using the Gordon Growth method to calculate its Terminal Value. ACME Co. has consistently outperformed its peers and is ahead of every other company in the industry by a longshot. What would be a reasonable assumption for the long-term growth rate you use when calculating Terminal Value in the DCF? a. 2-3% b. 9-10% c. 5-7% d. Unable to determine this without looking at FCF growth from peer companies
Explanation: Regardless of how quickly the company has grown historically, you should never use a long-term growth rate far in excess of the country's GDP growth rate or the rate of inflation. Think about the math for a second there: if you assume that the company grows faster than the economy as a whole far into the future, eventually the company itself will be bigger than the economy of the entire country, which is impossible. So 9-10% is far too high, and even 5-7% is too high. 2-3% is more reasonable because that is in-line with the country's GDP growth rate. D is incorrect because we know that the company has outperformed its peers, so getting their FCF growth rates would not make a big difference here.
30. Assume ACME Co. has a revenue growth rate of 10% over a 5-year period and a Cost of Equity of 10%. Which will have a greater impact on Equity Value: reducing the revenue growth rate TO 1% or reducing the Cost of Equity TO 9%? a. Reducing the revenue growth rate TO 1% b. Reducing the Cost of Equity TO 9% c. It depends on the company in question d. You can't determine the impact with Cost of Equity, only with WACC
Explanation: The correct answer choice is A. In this case, we are reducing the revenue growth rate by 90% versus only lowering the Cost of Equity (aka 'discount rate') by 10%. In this scenario the final Equity Value would most likely be impacted more by the revenue growth rate reduction because that lower revenue growth rate affects Free Cash Flows over the near future period as well as the Terminal Value. Normally, the discount rate tends to have a bigger impact, but when you're looking at a 90% change in revenue growth vs. a 10% change in the discount rate, the revenue growth rate change will almost always have a bigger impact. It would be much tougher to assess if it were, say, a 40% change in revenue growth vs. a 20% change in the discount rate, and in that case it really could go either way. D is incorrect because it's clear that we're using a Levered FCF analysis here due to the "Equity Value" reference, so WACC isn't even relevant.
31. Assume ACME Co. is financed 100% with equity and decides to change its capital structure to 90% equity and 10% debt. What would happen to its overall WACC? a. WACC would decrease b. WACC would increase c. WACC would remain the same d. None of the above
Explanation: The correct answer choice is A. Note that we are not given its Cost of Equity or WACC - but we don't actually need numbers for those figures. The general idea is that when a company is completely financed with equity and decided to issue a small amount of debt, the WACC in most cases will decrease because the Cost of Debt is almost always lower than the Cost of Equity, thus driving the WACC down. Two things to keep in mind are that we use the after-tax cost of Debt (as interest expense is tax deductible) which is lower than the Cost of Equity in 99.9% of cases, and also that Debt interest rates by themselves (usually under 10%) tend to be lower than the Cost of Equity (often over 10%) to begin with.
33. Company A and B generate the same total Free Cash Flow over 5 years. But Company A generates 90% of its FCFs in the initial 2 years, whereas Company B generates 20% in each year. Assuming the same discount rate, which company's FCFs have a higher NPV? a. Company A b. Company B c. Both have the same NPV d. It depends on the discount rate - you can't tell with the information given
Explanation: The correct answer choice is A. The concept here is that Free Cash Flows generated earlier are worth more than the same amount generated in later periods. This comes back to the time value of money: money today is worth more than money tomorrow because you could re-invest money today and earn interest on it. In a DCF context, if both companies have identical cash flows but one produces higher cash flows upfront, the NPV of those cash flows will be higher because cash flows in earlier periods have less of a discount applied. D is incorrect because the discount rate is irrelevant as long as you're using the same rate for both companies - this is about the concept of the time-value of money, not the specific numbers.
6. In a valuation context, using Unlevered FCF in a DCF gets you Enterprise Value, whereas using Levered FCF gets you Equity Value. a. True b. False
Explanation: The correct answer choice is A. The statement above is true. This is the case is because Unlevered FCF is available to all investors in the firm (both debt and equity), whereas Levered FCF included interest payments and mandatory debt repayments, which means that the remaining cash flows are available only to equity investors.
25. The Gordon Growth method for calculating Terminal Value can always be used as a substitute to the Terminal Multiple method in all situations. a. True b. False
Explanation: The correct answer choice is B. Most of the time, either method can be used and in practice you can move from one to the other by working backwards. However, given the way the mathematics of the Gordon Growth Model (GGM) are set up, if the Discount Rate happens to be lower than the terminal period growth rate, the GGM will produce a negative value for Terminal Value (as the denominator would result in a negative number), thereby making the value meaningless. Another scenario that can render the GGM less meaningful is when the difference between the Discount Rate and the perpetuity growth rate is big; in this scenario, you would get outsized Terminal Values. Finally, if you lack sufficient information to determine long-term growth rates, then the GGM may not be as applicable when calculating Terminal Value.
29. Assume ACME Co. has a 10% revenue growth rate over a 5-year period, and a WACC of 10%. Which will have a bigger impact in a DCF: reducing the revenue growth rate to 9% or reducing WACC to 9%? a. Reducing revenue growth by 1%, to 9% rather than 10% b. Reducing WACC by 1%, to 9% rather than 10% c. Both will have same effect d. It's impossible to guess without additional information
Explanation: The correct answer choice is B. The key concept here is that even small changes in the discount rate will have an enormous impact on the model, much more so than small changes in revenue growth. In terms of valuation, a reduced WACC has a much greater effect on total value than a 100 basis point drop in revenue growth rate, because the latter will affect our Free Cash Flow calculations slightly, whereas the lower WACC discount rate is applied to all the Free Cash Flows in both the 'near future' and 'far future,' and therefore has a much greater impact on the Terminal Value, which usually comprises the majority of value in a DCF.
7. When trying to calculate Free Cash Flow (either Unlevered or Levered), increases in operating assets - AR, inventory, etc. - represent a source of cash (a cash inflow) while decreases in operating liabilities - AP, accrued expenses, etc. - also represent a source of cash (a cash inflow). a. True b. False
Explanation: The correct answer choice is B. The statement above is false. On the contrary, an increase in an operating asset represents a use of cash, NOT a source of cash. On the other hand, a decrease in operating liabilities represents a use of cash, NOT a source of cash. Let's say that Inventory increases. In order for Inventory - an operating asset - to increase, cash must have been used to purchase additional Inventory. The same actually applies to any Operating Asset - an increase to an Asset implies that you have spent cash to acquire that Asset. The opposite is true for Liabilities - for example, if you raise Debt you get extra cash as a result; if Deferred Revenue, Accounts Payable, or Accrued Expenses go up, you also get extra cash because you collect additional cash up-front, or you're waiting longer to pay out cash.
10. WACC should always be used as the Discount Rate, regardless of the type of Free Cash Flow you're using in a DCF analysis. a. True b. False
Explanation: The correct answer choice is B. The weighted average cost of capital - which includes both cost of equity and cost of debt - should only be used when you're using Unlevered FCF as that cash flow is available to both debt and equity investors. On the other hand, when calculating Levered FCF one should use just the cost of equity (NOT WACC) to discount such cash flows as they represent what is available only to equity investors (i.e. they are after both interest expense and debt repayments have been made).
32. Assume ACME Co. is financed 100% with equity and decides to recapitalize itself to have 25% debt and 75% equity in its capital structure. What would happen to the Cost of Equity? a. Cost of Equity would decrease b. Cost of Equity would increase c. Cost of Equity would stay the same since it's not dependent on the capital structure or the amount of debt the company has d. Need more information to determine the answer
Explanation: The correct answer choice is B. Think about the formula for Cost of Equity: Risk-Free Rate + Equity Risk Premium * Levered Beta. The Risk-Free Rate and Equity Risk Premium would not change here. However, Levered Beta would increase if the company raises additional Debt because its overall risk is higher. And yes, the normal equity investors (shareholders) are still impacted by Debt because it increases risk for them as well: the company has a higher chance of going bankrupt, for example. So C is incorrect because Cost of Equity IS, in fact, impacted by capital structure. A is incorrect because additional Debt would always increase Levered Beta, which pushes Cost of Equity up. D is incorrect because additional Debt, all else being equal, always increases Cost of Equity.
11. Which of the formulas below correctly calculates WACC? a. Cost of Equity * (% Equity) * (1 - Tax Rate) + Cost of Debt * (% Debt) * (1 - Tax Rate) + Cost of Preferred Stock * (% Preferred) b. Cost of Equity * (% Equity) * (1 - Tax Rate) + Cost of Debt * (% Debt) + Cost of Preferred Stock * (% Preferred) c. Cost of Debt * (% Debt) * (1 - Tax Rate) + Cost of Equity * (% Equity) + Cost of Preferred Stock * (% Preferred) d. Cost of Debt * (% Debt) + Cost of Equity * (% Equity) + Cost of Preferred Stock * (% Preferred)
Explanation: The correct answer choice is C. Answer choice A is incorrect because the Cost of Equity is NOT tax-affected since dividends are not tax deductible in the same way that interest expense on debt is. Answer choice B is incorrect because the (1 - tax rate) should be on the cost of debt, not cost of equity. Answer choice D is incorrect because the formula does not take into account the tax-deductibility of debt financing. As you can see from the answer choices, you never multiply the Cost of Preferred Stock by (1 - Tax Rate) because just like dividends to common shares, Preferred Dividends are also not tax- deductible.
19. Consider the values for Beta listed below. With which value would a stock move in the OPPOSITE direction from the overall market? a. Beta = 1.0 b. Beta = 0.5 c. Beta = -1.0 d. Beta = 2.0 e. Beta = 0.0
Explanation: The correct answer choice is C. The Beta of the market as a whole is assumed to be 1.0, so answer choice A would move directly in proportion to the overall market. A Beta of less than 1.0 would indicate the stock is less volatile than the market as a whole; however, the stock would still move in the same direction as the overall market. The same applies for B and D, only they move less or more in that same direction. Answer E corresponds to a stock that is completely independent of the overall market. Only a stock with a negative Beta would move in the OPPOSITE direction as the overall market, thereby making answer choice C the correct answer. Negative Betas are theoretically possible, but are extremely rare to nonexistent for normal stocks and you usually only see them for other types of assets such as certain commodities.
26. Which of the following statements is TRUE regarding the 'intuition' behind Terminal Value when calculated using the Gordon Growth method? a. It represents the present value of Free Cash Flows generated into perpetuity b. It represents the 'capitalized' value of ongoing Free Cash Flow generation at a constant growth rate into infinity c. Given a constant cash payment received and required return rate on our part, it represents the amount we can "afford" to pay up front now for future steam of cash (e.g. we can pay $100 now if we're aiming for a 10% return over 5 years from a set of cash flows) d. All of the above e. None of the above
Explanation: The correct answer choice is D. All of the above statements are true reflections of the 'intuition' behind the Gordon Growth Method (GGM) of calculating Terminal Value (TV). Basically the GGM is a mathematical simplification to a complex problem of having to project Free Cash Flows beyond our 5-year projection period. As described in the DCF Guide, these Free Cash Flows into perpetuity represent a 'geometric series' in which we can determine the value of that entire stream of FCF in the 'far future' period by applying the GGM formula. The GGM formula is Yr. 5 FCF * (1 + Growth Rate) / (Discount Rate - Growth Rate). Mathematically, what this formula is doing is taking the final period FCF projected and growing it by the steady state growth rate. It then takes that figure and 'capitalizes' it by dividing by the appropriate discount rate less that same steady state growth rate. The concept is difficult to grasp at first but it is basically a mathematical 'short-cut' solution to the messy problem of projecting FCF from year 5 to infinity. If you look at the questions and answers included in the interview guide, we address the intuition there and give an example of how it works. The easiest way to think of it is answer choice C - given a required return rate and a stream of cash flows, what could we pay to achieve that return?
8. All of the following are correct definitions of Levered Free Cash Flow (FCFE) EXCEPT: a. Net Income + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx - Mandatory Debt Repayments b. (EBIT - Net Interest Expense) * (1 - Tax Rate) + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx - Mandatory Debt Repayments c. CFO - CapEx - Mandatory Debt Repayments d. NOPAT + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx
Explanation: The correct answer choice is D. Answer choices A thru C are all correct, albeit slightly different, formulae that result in Levered Free Cash Flow (FCFE). Answer choice D is a trick question in that it substituted 'NOPAT' - namely, Net Operating Profits After Tax - in place of the usual "EBIT * (1 - tax rate)"; these two phrases are synonymous. The key mistake with answer choice D is that the formula provided is for unlevered - as opposed to levered - free cash flow, because NOPAT excludes interest income and expense, as well as mandatory debt repayments.
28. When calculating Terminal Value, how can you check your calculations and ensure that the number you've calculated is not completely wrong? a. Use both the Terminal Multiple method and Gordon Growth method and compare the numbers b. Work backwards to determine the implied Long-Term growth rate, based on the Terminal Value calculated with the Multiples method c. Work backwards to determine implied Terminal EBITDA multiple, based on the Terminal Value calculated with the Gordon Growth method d. All of the above
Explanation: The correct answer choice is D. The Terminal Value (TV) constitutes the majority of value in a DCF analysis. Therefore, it is important to ensure that this TV value is correct. In practice, bankers usually use the Terminal Multiple method to determine TV. However, both methods can be used so as to crosscheck the value produced by either method. It is usually a good idea to use both methods, and then to work backwards to determine what the 'implied Long-term growth rate' is using the Terminal Multiple method, and what the 'implied EBITDA multiple' would be using the Gordon Growth method. The reason this is used as a sanity check is because if you use the Terminal Multiple method to calculate TV, and then work backwards and determine the implied Long-Term Growth Rate is 12%, then this is a clear indication that the EBITDA multiple used is incorrect - a company growing at 12% forever would eventually surpass the size of the world's economy.
4. All of the following equations below are the correct definition of Unlevered Free Cash Flow (Free Cash Flow to Firm) EXCEPT: a. EBIT * (1 - Tax Rate) + Non-Cash Charges - Change in Operating Assets and Liabilities - CapEx b. CFO + Net Interest Expense * (1 - Tax Rate) - CapEx c. Net Income + Net Interest Expense * (1 - Tax Rate) + Non-Cash Charges - Change in Operating Assets and Liabilities - CapEx d. Net Income + Non-Cash Charges - Change in Operating Assets and Liabilities - CapEx - Mandatory Debt Repayments e. None of the above (i.e. these are all correct)
Explanation: The correct answer choice is D. Unlevered Free Cash Flow can be defined in more than one way, and answer choices A, B, and C are all correct definitions of unlevered FCF. Answer choice D, on the other hand, is NOT the definition of Unlevered FCF but rather is the correct formula for Levered free cash flow (since it includes interest payments and debt repayment).
15. When calculating the Cost of Equity, we always need to go through the process of un-levering Beta for each comparable company, finding the median, and then re-levering based on the company's own capital structure. a. True b. False
Explanation: There is no absolute requirement that you have to do this, but it is the most common method for estimating Beta in the Cost of Equity formula. The logic is that you get "more accurate" numbers by factoring in the median "inherent business risk" of all the comparable companies than you do by only looking the riskiness of the company you're valuing. However, you could just use the historical Beta of the company you're valuing. It's not necessarily "wrong," and the two numbers are often very close, especially in highly fragmented markets with lots of similar competitors.
20. ACME Co. had a Cost of Equity of 11% before a prolonged recession began. If all else remains equal and the company's financial performance continues as expected, what might its Cost of Equity change to once the recession starts? a. 13% b. 9% c. 11% - No changes d. Impossible to say without knowing its capital structure
Explanation: Think about the individual components here: Cost of Equity = Risk-Free Rate + Equity Risk Premium * Beta. It is reasonable to assume that the risk-free rate (as measured by the rate on a long dated Treasury bond) would drop once the economy enters into a recession. However, the other two components of Cost of Equity would almost certainly increase more than enough to offset the drop in risk-free rate - because in a recession, stocks fluctuate far more and investors become willing to pay a premium for superior performance and returns. There's another way to think about this as well: in a recession, all else being equal, does a company's Equity Value increase or decrease? Since 99% of companies' stock prices decline, resulting in lower Equity Values, that implies that the Cost of Equity has increased since that's what you use when discounting cash flows in a Levered DCF to arrive at Equity Value. D is incorrect because Debt and Preferred Stock do not affect Cost of Equity, only WACC.
17. When you discount Unlevered Free Cash Flows, you use Unlevered Beta in the Cost of Equity calculation, but when you discount Levered Free Cash Flows you use Levered Beta. a. True b. False
Explanation: This is a trick question intended to confuse you and test whether you really understand the concepts. To discount Unlevered FCF, you use WACC and to discount Levered FCF you use Cost of Equity... but the Cost of Equity calculation itself never changes regardless of which Discount Rate you use. The reason it never changes is that Debt and Equity both make an impact on the overall riskiness of a company regardless of whether you're looking at Unlevered or Levered FCF. So effectively you always have to use Levered Beta when calculating Cost of Equity - Unlevered Beta is just a by-product of an intermediate step in the process.
5. Which sections of the Cash Flow Statement do we generally exclude when calculating Free Cash Flow? a. Cash Flow from Operations (CFO) b. Cash Flow from Investing (CFI), except for CapEx c. Cash Flow from Financing (CFF) d. None of the above - we need all these sections when calculating FCF
Explanation: When calculating Unlevered FCF we only take CapEx from CFI and exclude everything else in that section as well as CFF. The idea is that we are trying to only include recurring, predictable items. And in the case of Levered FCF, we still exclude almost everything from CFI and CFF sections (with the exception of CapEx in FI and mandatory debt repayments in CFF). Most other items in CFI and CFF are usually one-time, non-recurring items (e.g. debt and equity issuances, sales of assets and securities) that in the majority of cases do not represent recurring, predictable sources or uses of cash for the company.
1. Conceptually, a DCF analysis consists of a "near future" value (over 5-10 years) and a "far future" value (the company's value past that period), both of which are discounted back to their present values and summed up. a. True b. False
i. Explanation: The correct answer choice is A. The "near future" value consists of the projected Free Cash Flows over the next 5 to 10 years, until the company reaches a steady state. The "far future" value represents the Free Cash Flows generated in the final year of the projection until perpetuity, and is approximated by the Terminal Value, which can be calculated using two differed approaches. Both values are discounted back to present and added together to determine Enterprise (or Equity) value, depending on which type of Free Cash Flows is projected.
