I 2

Why is the cost of debt lower?

Debt is senior in the capital structure and has first claim on assets in the event of bankruptcy. Therefore it demands a lower return.

If working capital increases, would that increase or decrease FCF?

Decrease

How do the 3 statements link together?

Net Income from the Income Statement flows into Shareholders' Equity on the Balance Sheet, and into the top line of the Cash Flow Statement. Changes to Balance Sheet items appear as working capital changes on the Cash Flow Statement, and investing

If I have a graph with WACC on the Y axis and Debt/Equity on the X axis, what would that curve look like?

A "U" or a parabola. WACC will initially decrease as you increase Debt/Equity due to the lower cost of debt. However your equity beta, which determines the cost of equity and counteract the advantages of debt.

What is beta? What are limitations of beta?

Beta is a measure of systematic risk and price volatility. Beta is based on historical performance, so not always the best indicator of the future. Standardized covariance between market return and individual security return,

When using the CAPM for purposes of calculating WACC, why do you have to unlevered and then relever Beta?

Beta takes each company's debt into account and is not capital structure neutral. In order to use the beta of comparable companies one must unlevered it. You then relever it with your company's D/E ratio to get a Beta that is accurate for your capital structure.

How does Free Cash Flow differ from Cash from Operations?

Cash from operations will not include capital expenditures. Cash from operations is a levered value, because interest expense is in net income. Cash from operations will include the tax effects of some non-cash items not included in the Free Cash Flow calculation (i.e. Impairments, acquired in-process R&D)

How do you calculate the cost of equity? Debt?

Cost of Equity is calculated using CAPM. Cost of debt is the yield on the most recent bond issuance.

Starting from revenue, how would you calculate Free Cash Flow?

Deduct COGS and Operating Expenses to get operating income (EBIT). Then follow equation above.

You mentioned CAPEX? Would that be Maintenance CAPEX or Growth CAPEX?

Maintenance. We want to see the Free Cash Flow in the everyday working of the company. However, maintenance CAPEX will be hard to separate from growth as it is not required to be reported separately.

Does a change in Net Working Capital include Cash Changes?

No, this component of the FCF calculation is meant to show sources of Cash that don't match up with the Net Income figure. Example would be buying inventory. That won't show up on the Income Statement until you sell it. But you use cash and need to recognize it. Cash is something that doesn't come into play in the NWC calculation because it would serve no purpose.

How do you calculate the value of a terminal year cash flow? Say 10 yrs.

Primarily use the terminal multiple method (EBITDA multiple). TY FCF = FCF (base 10) * (1 + g)/(Rd - g)

How do you calculate CAPM?

Re = Rf + B(Rm - Rf). Risk free rate (yield on a US 10-year gov bond) + company's Beta times the market risk premium. Market risk premium = Average return on the market - the risk free rate.

How could I reduce WACC?

Somehow lower either your cost of debt or equity. More likely re-adjust your capital structure more towards debt (lever up), because the cost of debt is lower.

What do you use for the risk free rate?

The yield on US Treasury Bonds (usually 10YR, but always try to match risk free rate to projection period)

When using CAPM for purposes of calculating WACC, what beta do we use?

Typically use an industry beta, which is calculated by taking the mean or media from a list of comparable firms. This beta will be levered, so it will need to be unlevered and then relevered to reflect the capital structure of the firm you are valuing.

FCF levered or unlevered?

Unlevered, because you don't include interest expense.

What is the formula for WACC?

WACC = W(D) * (1-T) * Cost(D) + W(PS) + W(CS) * Cost(CS); WACC is equal to the percentage of equity times cost of equity plus the percentage of debt times one minus the corporate tax rate times the cost of debt plus the percentage of preferred stock times the cost of preferred stock.

What value does a DCF give you?

Enterprise Value

What are the two ways to calculate terminal value?

Gordon Growth Model, EBITDA Multiples

Starting from Net Income, how would you calculate Free Cash Flow?

Add back Depreciation and Amortization. Deduct increases/add decreases in NWC. Deduct CAPEX. (Note: this is levered because interest expense has been deducted in Net Income. If they want unlevered, add Interest Expense).

How do you calculate Free Cash Flow?

Earnings before Interest and Taxes x (1 - Corporate Tax Rate) - Capital Expenditures (found on Cash Flow Statement) + Depreciation and Amortization (found on all three financial statements) - Net Increase or + Net Decrease in Working Capital (found on Cash Flow Statement) + Other relevant cash flows for an all equity firm = Free Cash Flow (or cash flow after maintaining the company)

Give me an example of a negative beta?

Gold

When would it be appropriate to forecast beyond 5-10 years?

It would be appropriate to do so when you have a very high growth firm, such as a start-up or a tech/bio-tech firm. It would also be appropriate to do so if the cash flows of the firm you are valuing are unrepresentative and normalized set of cash flows need to be forecasted.

How do you calculate the value of leveraged beta?

Levered Beta = Unlevered Beta * (1 + (1-T)(D/E)). Unlevered Beta = Levered Beta/(1+(1-T)(D/E)).

Why do you start with EBIT? Is it levered or un-levered?

We start with EBIT, because we want operating income before, taking into account, capital structure (interest) and taxes. EBIT is unlevered, because it does not take into account the capital structure (assumed all equity). We also want EBIT to be unlevered, because when we discount the free cash flow back, we use WACC, which is levered and accounts for capital structure. If the free cash flow and WACC were both levered, we would be deducting the cost of debt twice (as interest and expense and cost of debt are considered in the WACC formula).

What is Net Working Capital?

Working Capital = Current Assets - Current Liabilities. It's a measure of a company's efficiency and its short-term financial health. Shows if a company can meet its short-term liabilities with its current assets.

Name some non-recurring charges that need to be added back to a company's EBIT/EBITDA.

You want to add anything back that doesn't represent a common and recurring expense in the operations of the business. Ex: Restructuring charges, goodwill charges, asset write-downs, one-time legal expenses, excessive bad debt expense, disaster expenses, significant changes resulting from changes in accounting policies.

How would the DCF change if you used levered FCF (used EBT instead of EBIT)?

You wouldn't discount by WACC since WAVV is levered. You would discount by cost of equity. The ending value would be an equity value, not enterprise value.