Impact of Changes on a DCF and WACC
9. The Free Cash Flows in the projection period of a DCF analysis increase by 10% each year. How much will the company's Enterprise Value increase by?
A percentage that's less than 10%, for two reasons 1. Remember that we discount all those Free Cash Flows - so even if they increase by 10%, the present value change is less than 10%. 2. There's still the Terminal Value and the present value of that. That has not increased by 10%, so neither has the company's total value.
1. You're looking at two companies, both of which produce identical total Free Cash Flows over a 5-year period. Company A generates 90% of its Free Cash Flow in the first year and 10% over the remaining 4 years. Company B generates the same amount of Free Cash Flow in each year. Which one has the higher net present value?
Company A, because money today is worth more than money tomorrow. All else being equal, generating higher cash flow earlier on will always boost a company's value in a DCF.
3. What about WACC - will it be higher for a $5 billion or $500 million company?
If the capital structure is the same in terms of percentages and interest rates, then WACC should be higher for the $500 million company for the same reasons as mentioned above.
8. What about if we change revenue growth to 1%? Would that have a bigger impact, or would changing the Discount Rate to 9% have a bigger impact?
In this case the change in revenue growth is likely to have a bigger impact because you've changed it by 90% but you've only changed the Discount Rate by 10%
2. 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, because all else being equal, smaller companies are expected to outperform large companies in the stock
12. So if you're using Levered FCF to value a company, is the company better off paying off Debt quickly or repaying the bare minimum required?
It's always better to pay the bare minimum.
4. What's the relationship between Debt and Cost of Equity?
More Debt means that the company is riskier, so the company's Levered Beta will be higher
10. Let's say that we want to analyze all these factors in a DCF. What are the most common sensitivity analyses to use?
Revenue Growth vs. Terminal Multiple EBITDA Margin vs. Terminal Multiple Terminal Multiple vs. Discount Rate Terminal Growth Rate vs. Discount Rate
7. Let's say that we assume 10% revenue growth and a 10% Discount Rate in a DCF analysis. Which change will have a bigger impact: reducing revenue growth to 9%, or reducing the Discount Rate to 9%?
The Discount Rate change will almost certainly have a bigger impact because that affects everything from the present value of Free Cash Flows to the present value of Terminal Value
6. Wait a minute, so are you saying that a company that does not take on Debt is at a disadvantage to one that does? How does that make sense?
The one without Debt is not "at a disadvantage" - but it won't be valued as highly because of the way the WACC formula works.
5. Two 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 generally have a higher WACC because Debt is "less expensive" than Equity: Interest on Debt is tax-deductible - hence the (1 - Tax Rate) multiplication in the WACC formula. Debt is senior to Equity in a company's capital structure - debt investors would be paid first in a liquidation or bankruptcy scenario. Intuitively, interest rates on Debt are usually lower than Cost of Equity numbers (usually over 10%). As a result, the Cost of Debt portion of WACC will contribute less to the total figure than the Cost of Equity portion.
11. A company has a high Debt balance and is paying off a significant portion of its Debt principal each year. How does that impact a DCF?
Trick question. You don't account for this at all in an Unlevered DCF because you ignore interest expense and debt principal repayments.
