DCF Basic Part III

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. You can't give an exact number for the increase without knowing the rest of the numbers (Discount Rate, Terminal Value, etc.) in the analysis.

Let's say that we want to analyze all these factors in a DCF. What are the most common sensitivity analyses to use?

Common sensitivities: • Revenue Growth vs. Terminal Multiple • EBITDA Margin vs. Terminal Multiple • Terminal Multiple vs. Discount Rate • Terminal Growth Rate vs. Discount Rate

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.

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% - and that lower revenue growth will push down the present value of the Terminal Value (EBITDA and the FCF growth rate will both be lower) as well as the present value of the Free Cash Flows.

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 market (and are therefore "riskier").

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. Think about the math for a second: interest rates on Debt rarely go above 10-15%... let's just assume that they're 10%, and that the company has $1,000 in Debt. Initially, it pays $100 in interest expense, and after taxes that's only $60 ($100 * (1 - 40%)). So Levered Free Cash Flow is reduced by $60 each year assuming no principal repayment. What happens if the company decides to repay $200 of that Debt each year? Levered Free Cash Flow is down by at least $200 each year, and the company still pays interest, albeit lower interest, until the end of the period. So the company is always better off, valuation-wise, waiting as long as possible to repay Debt.

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 - so all else being equal, Cost of Equity would increase. Less Debt would decrease Cost of Equity

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 - and even a 10% change makes a huge impact.

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. Keep in mind that companies do not make big decisions based financial formulas. If a company has no reason to take on Debt (e.g. it is very profitable and does not need funds to expand its business), then it won't take on Debt.

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. Why? • 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.

What about WACC - will it be higher for a $5 billion or $500 million company?

This is a bit of a trick question because it depends on whether or not the capital structure is the same for both companies. 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. If the capital structure is not the same, then it could go either way depending on how much debt/preferred stock each one has and what the interest rates are.

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. In a Levered DCF, you factor it in by reducing the interest expense each year as the Debt goes down and also by reducing Free Cash Flow by the mandatory repayments each year. The exact impact - i.e. whether the implied Equity Value goes up or down - depends on the interest rate and the principal repayment percentage each year; however, in most cases the principal repayments far exceed the net interest expense, so the Equity Value will most likely decrease because Levered FCF will be lower each year.