Factors that affect a DCF Analysis
Should cost of equity and WACC be higher for a $5 billion or $500 million Equity Value company?
Assuming that both companies have the same capital structure percentages, cost of equity and WACC should both be higher for the $500 million company. Smaller companies tend to offer higher potential returns and higher risk than larger companies, which explains the higher cost of equity and WACC. Since smaller companies have a higher chance of defaulting on their debt, their cost of debt also tends to be higher.
Two companies produce identical total Free Cash Flows over a 10-year period, but Company A generates 90% of its Free Cash Flow in the first year and 10% over the remaining 9 years. Company B generates the same amount of Free Cash Flow in every year. Which company will have the higher implied value in a DCF?
If it's just this series of cash flows, company A will have the higher implied value because of the time value of money: the csh flows arrive earlier, so they're worth more. However, company B will almost certainly have a much higher terminal value because it has a much higher FCF in Year 10. So, if you count the PV of Terminal Value in the analysis, it's a good bet that Company B will have the higher implied value.
Which assumptions make the biggest impact on a DCF?
The discount rate and terminal value make the biggest impact on a DCF. Thats because the discount rate affects the PV of everything and because the PV of the terminal value often represents 50%+ of the company's implied value. The assumptions for revenue growth and operating margins also make a significant impact, but less than the ones above.
How does the tax rate affect the cost of equity, cost of debt, WACC, and the implied value from a DCF?
The tax rate affects the cost of equity, cost of debt, and WACC only if the company has debt. If the company does not have debt, or its targeted/optimal capital structure does not include debt, the tax rate doesn't matter because there's no tax benefit to interest paid on debt. If the company has some debt, a higher tax rate will reduce the cost of equity, cost of debt, and WACC. Its easy to see why it reduces the cost of debt: since you multiply by (1-Tax rate), a higher rate always reduces the after-tax cost. But it also reduces the cost of equity for the same reason: with a greater tax benefit, debt is less risky even to equity investors. And if both of these are lower, WACC will also be lower. However, the implied value from a DCF will also be lower because the higher tax rate reduces FCF and the company's terminal value. Those changes outweigh a lower WACC. The opposite happens with a lower tax rate: The cost of equity, cost of debt, and WACC are all higher, and the implied value is also higher.
Would increasing revenue growth from 9% to 10% or increasing the discount rate from 9% to 10% make a bigger impact on a DCF?
the discount rate increase will make a bigger impact. Increasing revenue growth from 9% to 10% will barely impact FCF and Terminal Value, but the discount rate will affect the present value of everything.
