DCF Model

10. 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

2. Why do you add back non-cash charges when calculating Free Cash Flow?

For the same reason you add them back on the Cash Flow Statement: you want to reflect the fact that they save the company on taxes, but that the company does not actually pay the expense in cash.

7. What do you usually use for the Discount Rate?

In a Unlevered DCF analysis, you use WACC (Weighted Average Cost of Capital), which reflects the "Cost" of Equity, Debt, and Preferred Stock. In a Levered DCF analysis, you use Cost of Equity instead.

5. Which method of calculating Terminal Value will produce a higher valuation?

It's impossible to say because it could go either way depending on the assumptions. There's no general rule here that always applies, or that even applies most of the time.

5. Why do you use 5 or 10 years for the "near future" DCF projections?

That's about as far as you can reasonably predict for most companies. Less than 5 years would be too short to be useful, and more than 10 years is too difficult to project for most companies.

3. Cost of Equity tells us the return that an equity investor might expect for investing in a given company - but what about dividends? Shouldn't we factor dividend yield into the formula?

Trick question. Dividend yields are already factored into Beta, because Beta describes returns relative to the benchmark (S&P)

8. Wait a second: why isn't the present value of the Terminal Value, by itself, just the company's Enterprise Value? Don't you get Enterprise Value if you apply a multiple to EBITDA?

Yes, you do get Enterprise Value - but that only represents the company's "far in the future" value. Remember that in a DCF, a company's value is divided into "near future" and "far future." If you leave out the present value of Free Cash Flows in the projection period, you're saying, "For the next 5 years, this company has no value. But then at the end of year 5, the company is miraculously worth something again!" And that doesn't make sense.

9. If you use Levered Free Cash Flow, what should you use as the Discount Rate?

You would use Cost of Equity rather than WACC since we're ignoring Debt and Preferred Stock and only care about the Equity Value for Levered FCF.

4. What about alternate ways to calculate Levered Free Cash Flow?

• Net Income + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx - Mandatory Debt Repayments • (EBIT - Net Interest Expense) * (1 - Tax Rate) + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx - Mandatory Debt Repayments • Cash Flow from Operations - CapEx - Mandatory Debt Repayments

2. Walk me through a DCF.

"A DCF values a company based on the Present Value of its Cash Flows and the Present Value of its Terminal Value. First, you project a company's financials using assumptions for revenue growth, margins, and the Change in Operating Assets and Liabilities; then you calculate Free Cash Flow for each year, which you discount and sum up to get to the Net Present Value. The Discount Rate is usually the Weighted Average Cost of Capital. Once you have the present value of the Free Cash Flows, you determine the company's Terminal Value, using either the Multiples Method or the Gordon Growth Method, and then you discount that back to its Net Present Value using the Discount Rate. Finally, you add the two together to determine the company's Enterprise Value."

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. 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.

10. Would you expect a manufacturing company or a technology company to have a higher Beta?

A technology company, because technology is viewed as a "riskier" industry than manufacturing.

6. What's the point of that "Changes in Operating Assets and Liabilities" section? What does it mean?

All it means is that if Assets are increasing by more than Liabilities, the company is spending cash and therefore reducing its cash flow, whereas if Liabilities are increasing by more than Assets, the company is increasing its cash flow. For example, if it places a huge order of Inventory, sells products, and records revenue, but hasn't receive the cash from customers yet, Inventory and Accounts Receivable both go up and represent uses of cash. Maybe some of its Liabilities, such as Accounts Payable and Deferred Revenue, also increase... but think about what happens: if the Assets increase by, say, $100, and the Liabilities only increase by $50, it's a net cash flow reduction of $50. So that is what this section is for - we need to take into account the cash changes from these operationally-linked Balance Sheet items.

15. Let's take a look at companies during the financial crisis (or really, just any type of crisis or economic downturn). Does WACC increase or decrease?

Break it down and think of the individual components of WACC: Cost of Equity, Cost of Debt, Cost of Preferred, and the percentages for each one. • The Risk-Free Rate would decrease because governments worldwide would drop interest rates to encourage spending. • But then the Equity Risk Premium would increase by a good amount as investors demand higher returns before investing in stocks. • Beta would also increase due to all the volatility. • So overall, we can guess that the Cost of Equity would increase because the latter two increases would likely more than make up for the decrease in the Risk-Free Rate. Now, for WACC: • The Cost of Debt and Cost of Preferred Stock would both increase as it would become more difficult for companies to borrow money. • The Debt to Equity ratio would likely increase because companies' share prices would fall, meaning that Equity Value decreased for most companies while Debt stayed the same... • So proportionally, yes, Debt and Preferred would likely make up a higher percentage of a company's capital structure. • But remember: the Cost of Debt and Cost of Preferred both increase, so that shift doesn't matter too much. • As a result, WACC almost certainly increases because almost all these variables push it up - the only one that pushes it down is the reduced Risk-Free Rate. There's a simpler way to think about it as well: all else being equal, did companies become more valuable or less valuable during the financial crisis? Less valuable - because the market discounted their future cash flows at higher rates. So WACC must have increased.

9. Let's say we do this and find that the Implied per Share Value is $10.00. The company's current share price is $5.00. What does this mean?

By itself, this does not mean much - you have to look at a range of outputs from a DCF rather than just a single number. So you would see what the Implied per Share Value is under different assumptions for the Discount Rate, revenue growth, margins, and so on. We used very aggressive assumptions or the company might be undervalued currently. A company being worth half of what we are saying it is intrinsically worth is a very big jump. If you consistently find that it's greater than the company's current share price, then the analysis might tell you that the company is undervalued; it might be overvalued if it's consistently less than the current share price across all ranges.

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.

2. How do you calculate Cost of Equity?

Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered Beta i) The Risk-Free Rate represents how much a 10-year or 20-year US Treasury (or equivalent "safe" government bond in your own country) should yield. ii) Beta is calculated based on the "riskiness" of Comparable Companies iii) Equity Risk Premium is the percentage by which stocks are expected to out-perform "risk-less" assets like US Treasuries. Normally you pull the Equity Risk Premium from a publication called Ibbotson's. Note: Depending on your bank and group, you might also add in a "size premium" and "industry premium" to account for additional risk and expected returns from either of those. Small-cap stocks are expected to out-perform large-cap stocks and certain industries are expected to out-perform others, and these premiums reflect these expectations.

5. How do you calculate Beta in the Cost of Equity calculation?

First off, note that you don't have to calculate anything - you could just take the company's Historical Beta, based on its stock performance vs. the relevant index. Normally, however, you come up with a new estimate for Beta based on the set of Public Comps you're using to value the company elsewhere in the Valuation, under the assumption that your estimate will be more accurate. You look up the Beta for each Comparable Company (usually on Bloomberg), un-lever each one, take the median of the set and then lever that median based on the company's capital structure. Then you use this Levered Beta in the Cost of Equity calculation. The formulas for un-levering and re-levering Beta are below: • Unlevered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Total Debt/Equity))) • Levered Beta = Unlevered Beta x (1 + ((1 - Tax Rate) x (Total Debt/Equity)))

6. Can you explain the Gordon Growth formula in more detail? I don't need a full derivation, but what's the intuition behind it?

Here's the intuition behind it: Let's say that we know for certain that we'll receive $100 every year indefinitely, and we have a required return of 10%. That means that we can "afford" to pay $1,000 now ($100 / 10%) to receive $100 in year 1 and $100 in every year after that forever. But now let's say that that stream of $100 were actually growing each year - if that's the case, then we could afford to invest more than the initial $1,000. Let's say that we expect the $100 to grow by 5% every year - how much can we afford to pay now to capture all those future payments, if our required return is 10%? Well, that growth increases our effective return... so now we can pay more and still get that same 10% return. We can estimate that by dividing the $100 by (10% - 5%). 10% is our required return and 5% is the growth rate. So in this case, $100 / (10% - 5%) = $2,000. This corresponds to the formula above: $100 represents Final Year Free Cash Flow * (1 + Growth Rate), 10% is the Discount Rate, and 5% is the Growth Rate. The higher the expected growth, the more we can afford to pay upfront. And if the expected growth is the same as the required return, theoretically we can pay an infinite amount (you get a divide by zero error in the equation) to achieve that return. You can test this yourself by plugging the values into a spreadsheet: enter $100, make it grow by 5% each year, and then use NPV(10%, Area With All The Numbers) and you'll see how it approaches $2,000 as you add more to it:

2. Why would you use the Gordon Growth Method rather than the Multiples Method to calculate the Terminal Value?

In banking, you almost always use the Multiples Method to calculate Terminal Value in a DCF. It's easier to get appropriate data for exit multiples since they are based on Comparable Companies - picking a long-term growth rate involves more guesswork. However, you might use Gordon Growth if you have no good Comparable Companies or if you believe that multiples will change significantly in the industry several years down the road. For example, if an industry is cyclical (e.g. chemicals or semiconductors) you might be better off using long-term growth rates rather than exit multiples.

11. Shouldn't you use a company's targeted capital structure rather than its current capital structure when calculating Beta and the Discount Rate?

In theory, yes. If you know that a company's capital structure is definitely changing in a certain, predictable way in the future, sure, go ahead and use that. In practice, you rarely know this information in advance, so it's not terribly practical to make this kind of assumption.

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% - 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.

8. How do you treat Preferred Stock in the formulas above for Beta?

It should be counted as Equity there because Preferred Dividends are not tax-deductible, unlike interest paid on Debt.

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 market (and are therefore "riskier").

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 b/c how much you on save after tax interest is not sufficient to compensate for the amount that levered free cash flow is goes down by to pay off debt. So the company is always better off, valuation-wise, waiting as long as possible to repay Debt. 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.

8. Let's say that you use Levered Free Cash Flow rather than Unlevered Free Cash Flow in your DCF - what changes?

Levered Free Cash Flow gives you Equity Value rather than Enterprise Value, since the cash flow is only available to Equity Investors (Debt investors have already been "paid" with the interest payments and principal repayments).

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

1. Let's talk more about how you calculate Free Cash Flow. Is it always correct to leave out most of the Cash Flow from Investing section and all of the Cash Flow from Financing section?

Most of the time, yes, because all items other than CapEx are generally non- recurring, or at least do not recur in a predictable way. If you have advance knowledge that a company is going to sell or buy a certain amount of securities, issue a certain amount of stock, or repurchase a certain number of shares every year, then sure, you can factor those in. But it's extremely rare to do that.

10. Let's say that you use Unlevered Free Cash Flow in a DCF to calculate Enterprise Value. Then, you work backwards and use the company's Cash, Debt, and so on to calculate its implied Equity Value. Then you run the analysis using Levered Free Cash Flow instead and calculate Equity Value at the end. Will the implied Equity Value from both these analyses by the same?

No, most likely it will not be the same. In theory, you could pick equivalent assumptions and set up the analysis such that you calculate the same Equity Value at the end. In practice, it's difficult to pick "equivalent" assumptions, so these two methods will rarely, if ever, produce the same value. Think about it like this: when you use Unlevered FCF and move from Enterprise Value to Equity Value, you're always using the same numbers for Cash, Debt, etc. But in a Levered FCF analysis, the terms of the Debt will impact Free Cash Flow - so simply by assuming a different interest rate or repayment schedule, you'll alter the Equity Value. That's why it's so difficult to make "equivalent assumptions."

4. How do you select the appropriate exit multiple when calculating Terminal Value?

Normally you look at the Public Comps and pick the median of the set, or something close to it. You always show a range of exit multiples and what the Terminal Value looks like over that range rather than picking one specific number. So if the median EBITDA multiple of the set were 8x, you might show a range of values using multiples ranging from 6x to 10x.

3. What's an appropriate growth rate to use when calculating the Terminal Value?

Normally you use the country's long-term GDP growth rate, the rate of inflation, or something similarly conservative. For companies in developed countries, a long-term growth rate over 5% would be quite aggressive since most developed economies are growing at less than 5% per year.

7. What happens in the DCF if Free Cash Flow is negative? What if EBIT is negative?

Nothing "happens" because you can still run the analysis as-is. The company's value will certainly decrease if one or both of these turn negative, because the present value of Free Cash Flow will decrease as a result. The analysis is not necessarily invalid even if cash flow is negative - if it turns positive after a point, it could still work. If the company never turns cash flow-positive, then you may want to skip the DCF because it will always produce negative values.

8. If I'm working with a public company in a DCF, how do I move from Enterprise Value to its Implied per Share Value?

Once you get to Enterprise Value, ADD Cash and then SUBTRACT Debt, Preferred Stock, and Noncontrolling Interests (and any other debt-like items) to get to Equity Value. Then you divide by the company's share count (factoring in all dilutive securities) to determine the implied per-share price.

9. How do you know if a DCF is too dependent on future assumptions?

Some people claim that if over 50% of a company's value comes from the present value of the Terminal Value, the DCF is too dependent on future assumptions. The problem, though, is that in practice this is true in almost all DCFs. If the present value of the Terminal Value accounts for something like 80-90%+ of the company's value, then maybe you need to re-think your assumptions.

14. How do you determine a firm's Optimal Capital Structure? What does it mean?

The "optimal capital structure" is the combination of Debt, Equity, and Preferred Stock that minimizes WACC. There is no real way to determine this formulaically because you'll always find that Debt should be 100% of a company's capital structure since it's always cheaper than Equity and Preferred Stock... but that can't happen because all companies need some amount of Equity as well. Plus, taking on additional Debt will impact the Cost of Equity and the Cost of Preferred, so effectively it is a multivariable equation with no solution. You may be able to approximate the optimal structure by looking at a few different scenarios and seeing how WACC changes - but there's no mathematical solution.

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 directly the company's from the present value of Free Cash Flows & Terminal Value whereas the revenue growth does not affect FCF directly.

12. The "cost" of Debt and Preferred Stock make intuitive sense because the company is paying for interest or for the Preferred Dividends. But what about the Cost of Equity? What is the company really paying?

The company "pays" for Equity in two ways: 1. It may issue *Dividends* to its common shareholders, which is a cash expense. 2. It *gives up stock appreciation rights* to other investors, so in effect it's losing some of that upside - a non-cash but very real "cost." It is tricky to estimate the impact of both of those, which is why we usually use the Risk-Free Rate + Equity Risk Premium x Beta formula to estimate the company's expected return instead.

1. What's the basic concept behind a Discounted Cash Flow analysis?

The concept is that you value a company based on the present value of its Future Cash Flows You divide the future into a "near future" period of 5-10 years and then calculate, project, discount, and add up those Free Cash Flows; and then there's also a "far future" period for everything beyond that, which you can't estimate as precisely, but which you can approximate using different approaches. You need to discount everything back to its present value because money today is worth more than money tomorrow.

4. What's the point of Free Cash Flow, anyway? What are you trying to do?

The idea is that you're replicating the Cash Flow Statement, but only including recurring, predictable items. And in the case of Unlevered Free Cash Flow, you also exclude the impact of Debt entirely. That's why everything in Cash Flow from Investing except for CapEx is excluded, and why the entire Cash Flow from Financing section is excluded (the only exception being Mandatory Debt Repayments for Levered FCF).

7. What's the flaw with basing the Terminal Multiple on what the Public Comps are trading at?

The median multiples may change greatly in the next 5-10 years, so they may no longer be accurate by the end of the period you're looking at. This is why you look at a wide range of multiples and run sensitivity analyses to see how these variables impact the valuation.

10. How can you check whether your assumptions for Terminal Value using the Multiples Method vs. the Gordon Growth Method make sense?

The most common method here is to calculate Terminal Value using one method, and then to see what the implied long-term growth rate or implied multiple via the other method would be. Example: You calculate Terminal Value with a long-term growth rate assumption of 4%. Terminal Value is $10,000. You divide that Terminal Value by the final year EBITDA and get an implied EBITDA multiple of 15x - but the Public Comps are only trading at a median of 8x EBITDA. In this case your assumption is almost certainly too aggressive and you should reduce that long- term growth rate.

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. 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.

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 - you save money on taxes by paying interest on debt • Debt is senior to Equity in a company's capital structure - debt investors would be paid first in a liquidation or bankruptcy scenario. Therefore you owe less to the person giving debt • Equity is giving ownership to your cash flows forever, whereas debt you pay it down and you are done. • 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.

10. An alternative to the DCF is the Dividend Discount Model (DDM). How is it different in the general case (i.e. for a normal company, not a commercial bank or insurance firm?)

The setup is similar: you still project revenue and expenses over a 5-10 year period, and you still calculate Terminal Value. The difference is that you do not calculate Free Cash Flow - instead, you stop at Net Income and assume that Dividends Issued are a percentage of Net Income, and then you discount those Dividends back to their present value using the Cost of Equity. Then, you add those up and add them to the present value of the Terminal Value, which you might base on a P / E multiple instead (dividends come out of net income). Finally, a Dividend Discount Model gets you the company's Equity Value rather than its Enterprise Value since you're using metrics that include interest income and expense.

9. Can Beta ever be negative? What would that mean?

Theoretically, yes, Beta could be negative for certain assets. If Beta is -1, for example, that would mean that the asset moves in the opposite direction from the market as a whole. If the market goes up by 10%, this stock would go down by 10%. In practice, you rarely, if ever, see negative Betas with real companies. Even something labeled as "counter-cyclical" still follows the market as a whole; a "counter-cyclical" company might have a Beta of 0.5 or 0.7, but not -1.

3. Walk me through how you get from Revenue to Free Cash Flow in the projections.

There are many "alternate methods" - here are a few common ones: • EBIT * (1 - Tax Rate) + D&A - Changes in Operating Assets and Liabilities - CapEx • Cash Flow from Operations + Tax-Adjusted Net Interest Expense - CapEx • Net Income + Tax-Adjusted Net Interest Expense + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx The difference with these is that the tax numbers will be slightly different as a result of when you exclude the interest.

3. What's an alternate method for calculating Unlevered Free Cash Flow (Free Cash Flow to Firm)?

There are many "alternate methods" - here are a few common ones: • EBIT * (1 - Tax Rate) + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx • Cash Flow from Operations + Tax-Adjusted Net Interest Expense - CapEx • Net Income + Tax-Adjusted Net Interest Expense + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx The difference with these is that the tax numbers will be slightly different as a result of when you exclude the interest.

4. How can we calculate Cost of Equity WITHOUT using CAPM?

There is an alternate formula: Cost of Equity = (Dividends per Share / Share Price) + Growth Rate of Dividends This is less common than the "standard" formula but sometimes you use it when the company is guaranteed to issue Dividends (e.g. Utilities companies) and/or information on Beta is unreliable.

7. Would you still use Levered Beta with Unlevered Free Cash Flow?

They are different concepts (yes, the names get very confusing here). You always use Levered Beta with Cost of Equity because Debt makes the company's stock riskier for everyone involved. And you always use that same Cost of Equity number for both Levered Free Cash Flow, where Cost of Equity itself is the Discount Rate, and also for Unlevered Free Cash Flow, where Cost of Equity is a component of the Discount Rate (WACC).

3. 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.

13. If a firm is losing money, do you still multiply the Cost of Debt by (1 - Tax Rate) in the WACC formula? How can a tax shield exist if they're not even paying taxes?

This is a good point, but in practice you will still multiply by (1 - Tax Rate) anyway. What matters is not whether the Debt is currently reducing the company's taxes, but whether there's potential for that to happen in the future if a company has positive pre-tax profits. - even if the company isn't paying taxes right now, you could save money in the future.

5. As an approximation, do you think it's OK to use EBITDA - Changes in Operating Assets and Liabilities - CapEx to approximate Unlevered Free Cash Flow?

This is inaccurate because it excludes taxes completely. It would be better to use EBITDA - Taxes - Changes in Operating Assets and Liabilities - CapEx. If you need a very quick approximation, yes, this formula can work and it will get you closer than EBITDA by itself. But taxes are significant and should not be overlooked.

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. 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.

1. How do you calculate WACC?

WACC = Cost of Equity x (% Equity) + Cost of Debt x (% Debt) x (1 - Tax Rate) + Cost of Preferred x (% Preferred) In all cases, the percentages refer to how much each component comprises of the company's capital structure. For Cost of Equity, you can use the Capital Asset Pricing Model and for the others you usually look at comparable companies and comparable debt issuances and the interest rates and yields issued by similar companies to get estimates.

6. Why do you have to un-lever and re-lever Beta when you calculate it based on the comps?

When you look up the Betas on Bloomberg (or whatever source you're using) they will already be levered because a company's previous stock price movements reflect the Debt they've taken on. But each company's capital structure is different and we want to look at how "risky" a company is regardless of what % debt or equity it has. To do that, we need to un-lever Beta each time. We want to find the inherent business risk that each company has, separate from the risk created by Debt. (what is the middle calculation where you compare it to other companies and etc) But at the end of the calculation, we need to re-lever the median Unlevered Beta of that set because we want the Beta used in the Cost of Equity calculation to reflect the total risk of our company, taking into account its capital structure this time as well.

1. How do you calculate the Terminal Value?

You can either apply an exit multiple to the company's Year 5 EBITDA, EBIT or Free Cash Flow (Multiples Method) or you can use the Gordon Growth method to estimate the value based on the company's growth rate into perpetuity. The formula for Terminal Value using the Gordon Growth method: Terminal Value = Final Year Free Cash Flow * (1 + Growth Rate) / (Discount Rate - Growth Rate). Note that with either method, you're estimating the same thing: the present value of the company's Free Cash Flows from the final year into infinity, as of the final year.

6. Is there a valid reason why we might sometimes project 10 years or more anyway?

You might sometimes do this if it's a cyclical industry (chemicals) because it may be important to show the entire cycle from low to high.