DCF

What are the 4 main steps of calculating WACC?

1. Determine Target Capital Structure 2. Estimate Cost of Debt 3. Estimate Cost of Capital 4. Calculate WACC

How do you estimate the cost of debt?

A company's cost of debt reflects its credit profile at the target capital structure, which is based on a multitude of factors including size, sector, outlook, cyclicality, credit ratings, credit statistics, cash flow generation, financial policy, and acquisition strategy, among others. Assuming the company is currently at its target capital structure, cost of debt is generally derived from the blended yield on its outstanding debt instruments, which may include a mix of public and private debt. In the event the company is not currently at its target capital structure, the cost of debt must be derived from peer companies. For publicly traded bonds, cost of debt is determined on the basis of the current yield on all outstanding issues. For private debt, such as revolving credit facilities and term loans, the banker typically consults with an in-house debt capital markets (DCM) specialist to ascertain the current yield. Market-based approaches such as these are generally preferred as the current yield on a company's outstanding debt serves as the best indicator of its expected cost of debt and reflects the risk of default. In the absence of current market data (e.g., for companies with debt that is not actively traded), an alternative approach is to calculate the company's weighted average cost of debt on the basis of the at-issuance coupons of its current debt maturities. This approach, however, is not always accurate as it is backward-looking and may not reflect the company's cost of raising debt capital under prevailing market conditions. A preferred, albeit more time-consuming, approach in these instances is to approximate a company's cost of debt based on its current (or implied) credit ratings at the target capital structure and the cost of debt for comparable credits, typically with guidance from an in-house DCM professional. Once determined, the cost of debt is tax-effected at the company's marginal tax rate as interest payments are tax deductible

In step 1 of a DCF what things should you study of a target?

A thorough understanding of the target's business model, Business Profile, financial profile, value proposition for customers, competitors, and key risks is essential for developing a framework for valuation.

Accounts Payable

Accounts Payable refers to amounts owed by a company for products and services already purchased. A/P is customarily projected on the basis of days payable outstanding (DPO), AP/COGS. * 365 DPO measures the number of days it takes for a company to make payment on its outstanding purchases of goods and services. For example, a DPO of 30 implies that the company takes 30 days on average to pay its suppliers. The higher a company's DPO, the more time it has available to use its cash on hand for various business purposes before paying outstanding bills. An increase in A/P represents a source of cash. Therefore, as opposed to DSO, companies aspire to maximize or "push out" (within reason) their DPO so as to increase short-term liquidity.

Accounts Receivables

Accounts receivable refers to amounts owed to a company for its products and services sold on credit. A/R is customarily projected on the basis of days sales outstanding (DSO). DSO = AR/Sales. * 360 DSO provides a gauge of how well a company is managing the collection of its A/R by measuring the number of days it takes to collect payment after the sale of a product or service. For example, a DSO of 30 implies that the company, on average, receives payment 30 days after an initial sale is made. The lower a company's DSO, the faster it receives cash from credit sales. An increase in A/R represents a use of cash. Hence, companies strive to minimize their DSO so as to speed up their collection of cash. Increases in a company's DSO can be the result of numerous factors, including customer leverage or renegotiation of terms, worsening customer credit, poor collection systems, or change in product mix, for example. This increase in the cash cycle decreases short-term liquidity as the company has less cash on hand to fund short-term business operations and meet current debt obligations.

Accured Liabilities

Accrued liabilities are expenses such as salaries, rent, interest, and taxes that have been incurred by a company but not yet paid. As with prepaid expenses and other current assets, accrued liabilities and other current liabilities are typically projected as a percentage of sales in line with historical levels. As with A/P, an increase in accrued liabilities and other current liabilities represents a source of cash.

What is Beta?

Beta is a measure of the covariance between the rate of return on a company's stock and the overall market return (systematic risk), with the S&P 500 traditionally used as a proxy for the market. As the S&P 500 has a beta of 1.0, a stock with a beta of 1.0 should have an expected return equal to that of the market. A stock with a beta of less than 1.0 has lower systematic risk than the market, and a stock with a beta greater than 1.0 has higher systematic risk. Mathematically, this is captured in the CAPM, with a higher beta stock exhibiting a higher cost of equity; and vice versa for lower beta stocks.

What is the concept of present value?

Calculating present value centers on the notion that a dollar today is worth more than a dollar tomorrow, a concept known as the time value of money. This is due to the fact that a dollar earns money through investments (capital appreciation) and/or interest (e.g., in a money market account). In a DCF, a company's projected FCF and terminal value are discounted to the present at the company's WACC in accordance with the time value of money. The present value calculation is performed by multiplying the FCF for each year in the projection period and the terminal value by its respective discount factor. The discount factor is the fractional value representing the present value of one dollar received at a future date given an assumed discount rate. For example, assuming a 10% discount rate, the discount factor for one dollar received at the end of one year is 0.91 (see Exhibit 3.24).

What is Capex?

Capital expenditures are the funds that a company uses to purchase, improve, expand, or replace physical assets such as buildings, equipment, facilities, machinery, and other assets. Capex is an expenditure as opposed to an expense. It is capitalized on the balance sheet once the expenditure is made and then expensed over its useful life as depreciation through the company's income statement. As opposed to depreciation, capital expenditures represent actual cash outflows and, consequently, must be subtracted from EBIAT in the calculation of FCF (in the year in which the purchase is made).

Valuation multiples and growth rates

Company A - EV = $1000. EBITDA = $100 Lets say next year EBITDA grows at 10% to $110. Now the the EV/EBITDA is 9.1x, when before it was 10x. Company B = EV - $1000. EBITDA = $100 Lets say next year EBITDA grows by 5%, so it would be $105, EV/ EBITDA would be 9.5x Company A = 10% growth rate =lower multiple Company A = 5% growth rate - higher multiple

How do you calculate the cost of equity?

Cost of equity is the required annual rate of return that a company's equity investors expect to receive (including dividends).

What is WC

Current Assets - Current Liabilities BUT a better definition is Current Operational Assets - Current Operational Liabilities as we exclude cash, debt, investments sometime you'l see longer term operational items like deferred revenue included. Its not always the traditional 3 current assets and 3 current liabilities, its depends on the company's WC. You just have to look at the current assets line items and current liabilities line item. Sometimes current assets could just be inventory and other current assets decreases/increase in WC assets: prior year - current & increases/decreases in WC Liabilities: current year - prior If assets increase then cash goes out the door. So to get the math right we take the previous year minus the current year. The opposite is true of liabilities: take the current year minus the previous year. If a liability increases, we haven't yet paid a bill (or we borrowed money), resulting in a higher cash balance.

DIH (Days Inventory Held)

DIH measures the number of days it takes a company to sell its inventory. For example, a DIH of 90 implies that, on average, it takes 90 days for the company to turn its inventory (or approximately four "inventory turns" per year, as discussed in more detail below). An increase in inventory represents a use of cash. Therefore, companies strive to minimize DIH and turn their inventory as quickly as possible so as to minimize the amount of cash it ties up. Additionally, idle inventory is susceptible to damage, theft, or obsolescence due to newer products or technologies. An alternate approach for measuring a company's efficiency at selling its inven- tory is the inventory turns ratio. As depicted in the Exhibit 3.10, inventory turns measures the number of times a company turns over its inventory in a given year. As with DIH, inventory turns is used together with COGS to project future inventory levels. Inventory turns = COGS/Inventory

How do you forecast Depreciation? What types of depreciation methods are their?

Depreciation expenses are typically scheduled over several years corresponding to the useful life of each of the company's respective asset classes. The straight-line depreciation method assumes a uniform depreciation expense over the estimated useful life of an asset. For example, an asset purchased for $100 million that is determined to have a ten-year useful life would be assumed to have an annual depreciation expense of $10 million per year for ten years. Most other depreciation methods fall under the category of accelerated depreciation, which assumes that an asset loses most of its value in the early years of its life (i.e., the asset is depreciated on an accelerated schedule allowing for greater deductions earlier on). For DCF modeling purposes, depreciation is often projected as a percentage of sales or capex based on historical levels as it is directly related to a company's capital spending, which, in turn, tends to support top line growth.

What is D&A?

Depreciation is a non-cash expense that approximates the reduction of the book value of a company's long-term fixed assets or property, plant, and equipment (PP&E) over an estimated useful life and reduces reported earnings. Amortisation, like depreciation, is a non-cash expense that reduces the value of a company's definite life intangible assets and also reduces reported. statement, but these expenses are more commonly included in COGS (especially for manufacturers of goods) and, to a lesser extent, SG&A. Regardless, D&A is explicitly disclosed in the cash flow statement as well as the notes to a company's financial statements. As D&A is a non-cash expense, it is added back to EBIAT in the calculation of FCF (see Exhibit 3.4). Hence, while D&A decreases a company's reported earnings, it does not decrease its FCF.

What is NOPAT

EBIT*(1-tax rate)

When you do a sensitivity analysis what items can you sensitise

Equity Value Per Share - in the table you would have WACC on the y axis of the table, while Long term growth rate on the top

Formula for PGM

Final year FCF * (1+ FCF growth rate)/Discount rate - Growth rate

Capital structure hugely affects BETA

Financial leverage is essentially how much debt a firm has, how 'levered' it is, i.e. compared to equity, how much debt does a firm have in its capital structure? If a firm has high debt, this means it will also have high interest payments. High interest payments result in a lower profit. High interest and low profit means higher risks for shareholders. What is beta, essentially? Beta is a measure of risk. It tells you how much riskier a particular firm is compared to an index, like the Wilshire 5000 or the S&P index. For example, if a stock has a beta of 1.52, this means that if the returns on the market increase or decrease by 1%, the returns on that stock will increase or decrease by 1.52%, respectively. Now, if debt is risky, and if beta is a measure of riskiness, how will debt impact the Beta? You guessed it. Higher levels of debt will lead to a riskier firm, and thus a higher beta. Now lets move on to the technical explanation.

To learn about the company where does the banker retrieve the info from? THIS IS FOR PUBLIC

For a public company, a careful reading of its recent SEC filings (e.g., 10-Ks, 10-Qs, and 8-Ks), earnings call transcripts, and investor presentations provides a solid introduction to its business and financial characteristics. To determine key performance drivers, the MD&A sections of the most recent 10-K and 10-Q are an important source of information as they provide a synopsis of the company's financial and operational performance during the prior reporting periods, as well as management's outlook for the company. Equity research reports add additional color and perspective while typically providing financial performance estimates for the future two- or three-year period.

What about private, where do you get the information from?

For private, non-filing companies or smaller divisions of public companies (for which segmented information is not provided), company management is often relied upon to provide materials containing basic business and financial information. In an organised M&A sale process, this information is typically provided in the form of a CIM, (Confidential Information Memorandum). In the absence of this information, alternative sources must be used, such as company websites, trade journals and news articles, as well as SEC filings and research reports for public competitors, customers, and suppliers. For those private companies that were once public filers, or operated as a subsidiary of a public filer, it can be informative to read through old filings or research reports.

How do you project EBIT and EBITDA?

For public companies, EBITDA and EBIT projections for the future two - or three-year period are typically sourced from (or benchmarked against) consensus estimates, if available. These projections inherently capture both gross profit performance and SG&A expenses. A common approach for projecting EBITDA and EBIT for the outer years is to hold their margins constant at the level represented by the last year provided by consensus estimates (if the last year of es- timates is representative of a steady state level). As previously discussed, however, increasing (or decreasing) levels of profitability may be modelled throughout the pro- jection period, perhaps due to product mix changes, cyclicality, operating leverage, or pricing power/pressure. For private companies, the banker looks at historical trends as well as consensus estimates for peer companies for insight on projected margins. In the absence of sufficient information to justify improving or declining margins, the banker may simply hold margins constant at the prior historical year level to establish a baseline set of projection

How do you forecast sales projections?

For public companies, the banker often sources top line pro- jections for the first two or three years of the projection period from consensus estimates. Similarly, for private companies, consensus estimates for peer companies can be used as a proxy for expected sales growth rates provided the trend line is consistent with historical performance and sector outlook. As equity research normally does not provide estimates beyond a future two- or three-year period (excluding initiating coverage reports), the banker must derive growth rates in the outer years from alternative sources. Without the benefit of management guidance, this typically involves more art than science. Often, indus- try reports and consulting studies provide estimates on longer-term sector trends and growth rates. In the absence of reliable guidance, the banker typically steps down the growth rates incrementally in the outer years of the projection period to arrive at a reasonable long-term growth rate by the terminal year (e.g., 2% to 4%). For a highly cyclical business such as a steel or lumber company, however, sales levels need to track the movements of the underlying commodity cycle. Consequently, sales trends are typically more volatile and may incorporate dramatic peak-to-trough swings depending on the company's point in the cycle at the start of the projection period. Regardless of where in the cycle the projection period begins, it is crucial that the terminal year financial performance represents a normalized level as opposed to a cyclical high or low. Otherwise, the company's terminal value, which usually comprises a substantial portion of the overall value in a DCF, will be skewed toward an unrepresentative level. Therefore, in a DCF for a cyclical company, top line projections might peak (or trough) in the early years of the projection period and then decline (or increase) precipitously before returning to a normalized level by the terminal year. Once the top line projections are established, it is essential to give them a san- ity check versus the target's historical growth rates as well as peer estimates and sector/market outlook. Even when sourcing information from consensus estimates, each year's growth assumptions need to be justifiable, whether on the basis of market share gains/declines, end market trends, product mix changes, demand shifts, pricing increases, or acquisitions, for example. Furthermore, the banker must ensure that sales projections are consistent with other related assumptions in the DCF, such as those for capex and working capital. For example, higher top line growth typically requires the support of higher levels of capex and working capital.

What about COGS and indirect costs?

For public companies, the banker typically relies upon historical COGS (gross margin) and SG&A levels (as a percentage of sales) and/or sources estimates from research to drive the initial years of the projection period, if available. For the outer years of the projection period, it is common to hold gross margin and SG&A as a percentage of sales constant, although the banker may assume a slight improvement (or decline) if justified by company trends or outlook for the sector/market. Similarly, for private companies, the banker usually relies upon historical trends to drive gross profit and SG&A projections, typically holding margins constant at the prior historical year levels. At the same time, the banker may also examine research estimates for peer companies to help craft/support the assumptions and provide insight on trends In some cases, the DCF may be constructed on the basis of EBITDA and EBIT projections alone, thereby excluding line item detail for COGS and SG&A. This approach generally requires that NWC be driven as a percentage of sales as COGS detail for driving inventory and accounts payable is unavailable (see Exhibits 3.9, 3.10, and 3.11). However, the inclusion of COGS and SG&A detail allows the banker to drive multiple operating scenarios on the basis of gross margins and/or SG&A efficiency.

How do you project Capex?

Historical levels generally serve as a reliable proxy for projecting future capex. However, capex projections may deviate from historical levels in accordance with the company's strategy, sector, or phase of operations. For example, a company in expansion mode might have elevated capex levels for some portion of the projection period, while one in harvest or cash conservation mode might limit its capex. In the absence of specific guidance, capex is generally driven as a percentage of sales in line with historical levels due to the fact that top line growth typically needs to be supported by growth in the company's asset base.

How many years is a DCF projected for? What does this depend on? What are the basic steps of a DCF after projecting the financials?

In a DCF, a company's FCF is typically projected for a period of five years. The projection period, however, may be longer depending on the company's sector, stage of development, and the underlying predictability of its financial performance. The projected FCF and terminal value are discounted to the present at the target's weighted average cost of capital (WACC), which is a discount rate commensurate with its business and financial risks. The present value of the FCF and terminal value are summed to determine an enterprise value, which serves as the basis for the DCF valuation. Given the inherent difficulties in accurately projecting a company's financial performance over an extended period of time (and through various business and economic cycles), a terminal value is used to capture the remaining value of the target beyond the projection period (i.e., its "going concern" value). The WACC and terminal value assumptions typically have a substantial impact on the output, with even slight variations producing meaningful differences in valuation. As a result, a DCF output is viewed in terms of a valuation range based on a range of key input assumptions, rather than as a single value. The impact of these assumptions on valuation is tested using sensitivity analysis.

How many years should you project a DCF? Why does it depend? (3)

In a DCF, the target's FCF is typically projected for a period of five years, but this period may vary depending on the target's sector, stage of development, and the predictability of its FCF. However, five years is typically sufficient for spanning at least one business/economic cycle and allowing for the successful re- alization of in-process or planned initiatives. The goal is to project FCF to a point in the future when the target's financial performance is deemed to have reached a "steady state" that can serve as the basis for a terminal value calculation.

Inventory

Inventory refers to the value of a company's raw materials, work in progress, and finished goods.

What is the concept of a DCF? What is a company's projected FCF derived from?

It is premised on the principle that the value of a company, division, business, or collection of assets ("target") can be derived from the present value of its projected free cash flow (FCF). The valuation implied for a target by a DCF is also known as its intrinsic value - value based on a company's ability to generate cash flows) A company's projected FCF is derived from a variety of assumptions and judgments about its expected financial performance, including sales growth rates, profit margins, capital expenditures, and net working capital (NWC) requirements. PRESENT VALUE OF FUTURE CASH FLOWS, TO DO THAT YOU HAVE TO DISCOUNT IT! You use this when you want to cal PV of FCFF

What is CAPM?

Let's say Mark offers me a risk free interest of 2%, at Mark's bank. As the chance of the bank collapsing is extremely low it is regarded as risk free. Mark then offers me a second investment of medium risk (systematic risk) the risk of the overall stock market, but the interest you get here is also 2%. You would obviously still choose the risk free rate as you get the same return, but for lower risk. If Mark wants to convince you to move your money to th stock market how could he do that? He would have to offer you a premium. So the risk free rate + risk premium. (2% + 6%) = Total 8% return. CAPM is based on the premise that equity investors need to be compensated for their assumption of systematic risk in the form of a risk premium, or the amount of market return in excess of a stated risk-free rate. Systematic risk is the risk related to the overall market, which is also known as non- diversifiable risk. A company's level of systematic risk depends on the covariance of its share price with movements in the overall market, as measured by its beta (β) By contrast, unsystematic or "specific" risk is company- or sector-specific and can be avoided through diversification. Hence, equity investors are not compensated for it (in the form of a premium). As a general rule, the smaller the company and the more specified its product offering, the higher its unsystematic risk.

Change in Net Working Capital

Net working capital is typically de- fined as non-cash current assets ("current assets") less non-interest-bearing current liabilities ("current liabilities"). It serves as a measure of how much cash a company needs to fund its operations on an ongoing basis. All of the necessary components to determine a company's NWC can be found on its balance sheet

What considerations should you take when projecting financials?

Past growth rates, profit margins, and other ratios are usually a reliable indicator of future performance, especially for mature companies in non-cyclical sectors. This historical financial data is sourced from the target's financial statements with adjustments made for non-recurring items and recent events, as appropriate, to provide a normalized basis for projecting financial performance.

Prepaid Expenses

Prepaid expenses are payments made by a company before a product has been delivered or a service has been performed. For example, insurance premiums are typically paid upfront although they cover a longer term period (e.g., six months or a year). Prepaid expenses and other current assets are typically projected as a percentage of sales in line with historical levels. As with A/R and inventory, an increase in prepaid expenses and other current assets represents a use of cash.

What is the equation for CAPM?

Rf + Beta(Rm - Rf)

Restricted stock - once restricted/vested stock becomes

Should we just include vested stock? With Vested - it automatically gets included In the share count meaning there is no dilutive impact. What do we do with the unvested? We do include it in the share count - as it is highly likely that un vested restricted stock will in fact vest over the next several years (vesting periods average 1-3 years)

What is size premium?

Size Premium (SP) The concept of a size premium is based on empirical evidence suggesting that smaller sized companies are riskier and, therefore, should have a higher cost of equity. This phenomenon, which to some degree contradicts the CAPM, relies on the notion that smaller companies' risk is not entirely captured in their betas given limited trading volumes of their stock, making covariance cal- culations inexact. Therefore, the banker may choose to add a size premium to the CAPM formula for smaller companies to account for the perceived higher risk and, therefore, expected higher return (see Exhibit 3.18). Ibbotson provides size premia for companies based on their market capitalization, tiered in deciles. Vested means the employees have fulfilled their work requirements and are able to exercise their options or sell the restricted stock. Unvested means the employees have not fulfilled their work requirements so they cannot exercise their options or sell any restricted stock.

Net debt approach

So basically when we calculate debt in WACC, we use the net debt approach. This is because focusing on just a company's debt overestimates a company's observed beta. So inclusion of cash gives a more realistic view? Yes, that's correct. Another way to think of it is that if a company has a lot of it's capital (equity plus debt) tied up in a non-operating asset like cash, which is not earning much return, they will need to earn a higher return from their operations to satisfy the required return for debt and equity holders. So, cash not only affects beta, it also simply means lower returns for the investor capital that is sitting in cash. The observed beta for the cashflows of Apple is actually understated because of the huge net cash position - the market views the stock as less volatile, which doesn't necessarily mean the cash flows are, is that correct? And then following on, if we used a re-levered industry beta (as explored in lessons 58-59) then this disconnect wouldn't exist would it, so what would be the justification then?

Mid year convention explained.

So when you discount UFCF to their present value you do UFCF/(1+WACC)^n But what we are looking at here is the "n". The n value is the number of days between the valuation date and the time you discount. For example if look at the next slide, the valuation date is 2/28/2020, and if you are going to discount year 2 UFCF, the date of discount is 3/31/21. N represents the time between 2/28/2020 and 3/31/21. BUT the problem is if we assume the company receives all its cash flow at the end of every fiscal year i.e on the 3/31/21, the time will be a lot longer. That means a higher n, meaning a lower PV UFCF in the year. The lower the n the higher the PV UFCF. That means we would be discounting it too much. So the mid year convention basically says, lets cal the mid period date in that year and scout from there You can add a drop down menu to allow the analyst whether to pick the cash flows using the mid year convention or not. If you are able to teach when eh majority of cash flows come in (i.e seasonality that would be useful.

Outline Step 1: Public company vs Private company

Step I. Study the Target and Determine Key Performance Drivers. The first step in performing a DCF, as with any valuation exercise, is to study and learn as much as possible about the target and its sector. Shortcuts in this critical area of due diligence may lead to misguided assumptions and valuation distortions later on. This exercise involves determining the key drivers of financial performance (in particular sales growth, profitability, and FCF generation), which enables the banker to craft (or support) a defensible set of projections for the target. For private, non-filing companies, the banker often relies upon company management to provide materials containing basic business and financial information. In an organized M&A sale process, this information is typically provided in the form of a CIM (see Chapter 6). In the absence of this information, al- ternative sources (e.g., company websites, trade journals, and news articles, as well as SEC filings and research reports for public competitors, customers, and suppliers) must be used to learn basic company information and form the basis for developing the assumptions to drive financial projections.

Outline step 2 What is UFCF? The targets UFCF is driven by what kind of assumptions?

Step II. Project Free Cash Flow. The projection of the target's unlevered FCF forms the core of a DCF. Unlevered FCF, which we simply refer to as FCF in this chapter, is the cash generated by a company after paying all cash operating expenses and taxes, as well as the funding of capex and working capital, but prior to the payment of any interest expense. The target's projected FCF is driven by assumptions underlying its future financial performance, including sales growth rates, profit margins, capex, and working capital requirements. Historical performance, combined with third party and/or management guid- ance, helps in developing these assumptions.

Outline Step 3 What is WACC? Why is it used? What are other names for it? Is WACC dependent on capital structure?

Step III. Calculate Weighted Average Cost of Capital. In a DCF, WACC is the rate used to discount the target's projected FCF and terminal value to the present. It is designed to fairly reflect the target's business and financial risks. As its name connotes, WACC represents the "weighted average" of the required return on the invested capital (customarily debt and equity) in a given company. It is also commonly referred to as a company's "discount rate" or "cost of capital." As debt and equity components generally have significantly different risk profiles and tax ramifications, WACC is dependent on capital structure.

Outline step 4 What is the terminal value? Why is it important to get right?What is important to do? What methods do you use?

Step IV. Determine Terminal Value. The DCF approach to valuation is based on determining the present value of future FCF produced by the target. Given the challenges of projecting the target's FCF indefinitely, a terminal value is used to quantify the remaining value of the target after the projection period. The terminal value typically accounts for a substantial portion of the target's value in a DCF. Therefore, it is important that the target's financial data in the final year of the projection period ("terminal year") represents a steady state or normalized level of financial performance, as opposed to a cyclical high or low. There are two widely accepted methods used to calculate a company's termi- nal value—the exit multiple method (EMM) and the perpetuity growth method (PGM). The EMM calculates the remaining value of the target after the projec- tion period on the basis of a multiple of the target's terminal year EBITDA (or EBIT). The PGM calculates terminal value by treating the target's terminal year FCF as a perpetuity growing at an assumed rate.

Outline step 5 What is a sensitivity analysis? Is DCF a range of a single figure? What are common sensitised outputs?

Step V. Calculate Present Value and Determine Valuation. The target's projected FCF and terminal value are discounted to the present and summed to calculate its enterprise value. Implied equity value and share price (if relevant) can then be derived from the calculated enterprise value. The present value calculation is performed by multiplying the FCF for each year in the projection period,as well as the terminal value, by its respective discount factor. The discount factor represents the present value of one dollar received at a given future date assuming a given discount rate. As a DCF incorporates numerous assumptions about key performance drivers, WACC, and terminal value, it is used to produce a valuation range rather than a single value. The exercise of driving a valuation range by vary- ing key inputs is called sensitivity analysis. Core DCF valuation drivers such as WACC, exit multiple or perpetuity growth rate, sales growth rates, and margins are the most commonly sensitized inputs. Once determined, the valuation range implied by the DCF should be compared to those derived from other methodolo- gies such as comparable companies, precedent transactions, and LBO analysis (if applicable) as a sanity check.

What are the DCF 5 steps?

Study the Target and Determine Key Performance Drivers Project Free Cash Flow Calculate Weighted Average Cost of Capital Determine Terminal Value Calculate Present Value and Determine Valuation

What is Change in WC

The Change in Wc is what appears on a company's CFS and affects its cash flow On the CFS Change in WC = Old WC - New WC Example Imagine if WC was just Inventory Inventory. Year 1 Year 2 200 100. Change in inventory is -$100 As to increase your inventory by $100, you have to spend cash which cause a cash outflow causing change in inventory to be negative.. Its reduces the company's cash flow until the inventory is sold

What is the exit multiple method?

The EMM calculates the remaining value of a company's FCF produced after the projection period on the basis of a multiple of its terminal year EBITDA (or EBIT). This multiple is typically based on the current LTM trading multiples for com- parable companies. As current multiples may be affected by sector or economic cycles, it is important to use both a normalized trading multiple and EBITDA. The use of a peak or trough multiple and/or an un-normalized EBITDA level can produce a skewed result. This is especially important for companies in cyclical industries. As the exit multiple is a critical driver of terminal value, and hence overall value in a DCF, the banker subjects it to sensitivity analysis. For example, if the selected exit multiple range based on comparable companies is 6.5x to 7.5x, a common approach would be to create a valuation output table premised on exit multiples of 6.0x, 6.5x, 7.0x, 7.5x, and 8.0x (see Exhibit 3.32). The formula for calculating terminal value using the EMM is shown in Exhibit 3.20.

What is the perpetuity Growth Method?

The PGM calculates terminal value by treating a company's terminal year FCF as a perpetuity growing at an assumed rate. As the formula in Exhibit 3.21 indicates, this method relies on the WACC calculation performed in Step III and requires the banker to make an assumption regarding the company's long-term, sustainable growth rate ("perpetuity growth rate"). The perpetuity growth rate is typically chosen on the basis of the company's expected long-term industry growth rate, which generally tends to be within a range of 2% to 4% (i.e., nominal GDP growth). As with the exit multiple, the perpetuity growth rate is also sensitized to produce a valuation range.

Why are the assumptions both a positive and negative?

The assumptions driving a DCF are both its primary strength and weakness versus market-based valuation techniques. On the positive side, the use of defensible assumptions regarding financial projections, WACC, and terminal value helps shield the target's valuation from market distortions that occur periodically. In addition, a DCF provides the flexibility to analyze the target's valuation under different scenar- ios by changing the underlying inputs and examining the resulting impact. On the negative side, a DCF is only as strong as its assumptions. Hence, assumptions that fail to adequately capture the realistic set of opportunities and risks facing the target will also fail to produce a meaningful valuation.

What can affect EV?

The core business operations which represents the cash flow from the DCF. i.e lower venue growth = less revenue projected = less uFCF = lower EV Same with margins These cause the biggest changes and can be caused by company news i.e cutting unprofitable business, may cause higher operating margins in the future. Look at next two slides

How do you unleverage Beta for a private company?

The exercise of calculating WACC for a private company involves deriving beta from a group of publicly traded peer companies that may or may not have similar capital structures to one another or the target. To neutralize the effects of different capital structures (i.e., remove the influence of leverage), the banker must unlever the beta for each company in the peer group to achieve the asset beta("unlevered beta"). The formula for unlevering beta is shown in Exhibit 3.16.

What is the graph of the optimal capital structure What is the impact of capital structure on a company's WACC?

The graph in Exhibit 3.14 shows the impact of capital structure on a company's WACC. When there is no debt in the capital structure, WACC is equal to the cost of equity. As the proportion of debt in the capital structure increases, WACC gradually decreases due to the tax deductibility of interest expense. WACC continues to decrease up to the point where the optimal capital structure13 is reached. Once this threshold is surpassed, the cost of potential financial distress (i.e., the negative effects of an over-leveraged capital structure, including the increased probability of insolvency) begins to override the tax advantages of debt. As a result, both debt and equity investors demand a higher yield for their increased risk, thereby driving WACC upward beyond the optimal capital structure threshold.

What should the long term growth rate be for the perpetuity growth rate?

The long term growth rate should not be the historical growth rate of revenues. The global world economy will grow at a rate of 2-3%, if you say the company cash flows will grow at 8% per year (based on historical data of the cash flow of the company), due to compounding you are saying the company will grow bigger than the world economy. So you do have this constraint you normally predict a 2-4% Long term growth rate.

What is the market risk premium?

The market risk premium is the spread of the expected market return over the risk-free rate. Investment banks tend to have a value for this to make it consistent, but important for the banker to consult with senior colleagues with the figure should be.

How you analyse a company's performance i.e sales, growth, profitability? Give some examples? Why 2 types of drivers are there? Why do you have to do this?

The next level of analysis involves determining the key drivers of a company's per- formance (particularly sales growth, profitability, and FCF generation) with the goal of crafting (or supporting) a defensible set of FCF projections. These drivers can be both Internal (such as opening new facilities/stores, developing new prod- ucts, securing new customer contracts, and improving operational and/or work- ing capital efficiency). External (such as acquisitions, end market trends, consumer buying patterns, macroeconomic factors, or even legislative/regulatory changes). A given company's growth profile can vary significantly from that of its peers within the sector with certain business models and management teams more focused on, or capable of, expansion. Profitability may also vary for companies within a given sector depending on a multitude of factors including management, brand, customer base, operational focus, product mix, sales/marketing strategy, scale, and technology. Similarly, in terms of FCF generation, there are often meaningful differences among peers in terms of capex (e.g., expansion projects or owned versus leased machinery) and working capital efficiency, for example.

What is the risk free rate?

The risk-free rate is the expected rate of return obtained by investing in a "riskless" security. U.S. government securities such as T-bills, T-notes, and T-bonds16 are accepted by the market as "risk-free" because they are backed by the full faith of the U.S. federal government. Interpolated yields17 for government securities can be located on Bloomberg18 as well as the U.S. Department of Treasury website,19 among others. The actual risk-free rate used in CAPM varies with the prevailing yields for the chosen security. Investment banks may differ on accepted proxies for the appropriate risk-free rate, with some using the yield on the 10-year U.S. Treasury note and others prefer- ring the yield on longer-term Treasuries. The general goal is to use as long dated an instrument as possible to match the expected life of the company (assuming a going concern), but practical considerations also need to be taken into account.

What is the terminal value?

The terminal value typically accounts for a substantial portion of a company's value in a DCF, sometimes as much as three-quarters or more. Therefore, it is important that the company's terminal year financial data represents a steady state level of financial performance, as opposed to a cyclical high or low. Similarly, the underlying assumptions for calculating the terminal value must be carefully examined and sensitized.

Why is a DCF important?

The valuation implied for a target by a DCF is also known as its intrinsic value, as opposed to its market value, which is the value ascribed by the market at a given point in time. As a result, when performing a comprehensive valuation, a DCF serves as an important alternative to market-based valuation techniques such as comparable companies and precedent transactions, which can be distorted by a number of factors, including market aberrations (e.g., the post-subprime credit crunch). As such, a DCF plays an important role as a check on the prevailing market valuation for a publicly traded company. A DCF is also valuable when there are limited (or no) pure play, peer companies or comparable acquisitions.

What are the two methods for calculating the terminal value?

There are two widely accepted methods used to calculate a company's terminal value—the exit multiple method and the perpetuity growth method. Depending on the situation and company being valued, the banker may use one or both methods, with each serving as a check on the other

What is mid year convention?

To account for the fact that annual FCF is usually received throughout the year rather than at year-end, it is typically discounted in accordance with a mid-year convention. Mid-year convention assumes that a company's FCF is received evenly throughout the year, thereby approximating a steady (and more realistic) FCF generation. The use of a mid-year convention results in a slightly higher valuation than year-end discounting due to the fact that FCF is received sooner. As Exhibit 3.26 depicts, if one dollar is received evenly over the course of the first year of the projection period rather than at year-end, the discount factor is calculated to be 0.95 (assuming a 10% discount rate). Hence, $100 million received throughout Year 1 would be worth $95 million today in accordance with a mid-year convention, as opposed to $91 million using the year-end approach in Exhibit 3.25. Terminal Value Considerations When employing a mid-year convention for the projection period, mid-year discounting is also applied for the terminal value under the PGM, as the banker is discounting perpetual future FCF assumed to be received throughout the year. The EMM, however, which is typically based on the LTM trading multiples of comparable companies for a calendar year end EBITDA (or EBIT), uses year-end discounting.

What considerations should you take when working how many years the period should be?

Typically, the banker projects the target's FCF for a pe- riod of five years depending on its sector, stage of development, and the predictability of its financial performance. It is critical to project FCF to a point in the future where the target's financial performance reaches a steady state or normalized level. For mature companies in established industries, five years is often sufficient for allowing a company to reach its steady state. A five-year projection period typically spans at least one business cycle and allows sufficient time for the successful realization of in-process or planned initiatives. In situations where the target is in the early stages of rapid growth, however, it may be more appropriate to build a longer-term projection model (e.g., ten years or more) to allow the target to reach a steady state level of cash flow. In addition, a longer projection period is often used for businesses in sectors with long-term, contracted revenue streams such as natural resources, satellite communications, or utilities.

How do you cal enterprise value?

Value of core business operations Current Assets - Current liabilities (items apart of working capital) Remember Net debt = Debt - cash

WACC

WACC is a broadly accepted standard for use as the discount rate to calculate the present value of a company's projected FCF and terminal value. It represents the weighted average of the required return on the invested capital (customarily debt and equity) in a given company. As debt and equity components have different risk profiles and tax ramifications, WACC is dependent on a company's "target" capital structure.

Explain Step 1 on calculating WACC

WACC is predicated on choosing a target capital structure for the company that is consistent with its long-term strategy. This target capital structure is repre- sented by the debt-to-total capitalization (D/(D+E)) and equity-to-total capitaliza- tion (E/(D+E)) ratios (see Exhibit 3.12). In the absence of explicit company guidance on target capital structure, the banker examines the company's current and historical debt-to-total capitalization ratios as well as the capitalization of its peers. Public com- parable companies provide a meaningful benchmark for target capital structure as it is assumed that their management teams are seeking to maximize shareholder value. In the finance community, the approach used to determine a company's target capital structure may differ from firm to firm. For public companies, existing capital structure is generally used as the target capital structure as long as it is comfortably within the range of the comparables. If it is at the extremes of, or outside, the range, then the mean or median for the comparables may serve as a better representation of the target capital structure. For private companies, the mean or median for the comparables is typically used. Once the target capital structure is chosen, it is assumed to be held constant throughout the projection period.

Changes in WACC or cost of financing and effect

You need to understand that everything is interrelated i.e If debt increases from 10% to 30% this will in turn affect equity. Why? Because additional debt, makes the company financial position a lot riskier for everyone involved. Chance of bankruptcy is higher , so equity investor demand higher compensation for increased risk. Also changes in risk free rate - changes to this will impact everything, including cost of equity and cost of debt because both of them are tied to overall interest rates in the economy on "safe" government bonds

What is the UFCF equation?

[EBIT * (1-Tax rate)] + D&A - Capex - (increase/decrease in working capital)

Intuition behind PGM

https://www.youtube.com/watch?v=hCGn1ejYs1I

Look

use this for the perpetuity growth method to cal terminal value