DCF

Question 1

Walk me through a DCF.

Answer 1

Determine current free cash flow
Project free cash flow into the future
Determine a terminal free cash flow value
Discount all future free cash flows to the present using WACC
This gives you the present EV of the company
Subtract net debts to get present equity value

Question 2

How do you calculate free cash flow?

Answer 2

Earnings before interest and taxes
-CAPEX
\+Depreciation and Amortization
- Net increase (or decrease) in working capital
\+All other relevant cash flows
=free cash flow

Question 3

How does free cash flow differ from cash from operations?

Answer 3

Cash from operations will not include CAPEX
Cash from operations is levered
Cash from operations will include tax effects of some non cash items not included in the free cash flow calculation(ex R&D)

Question 4

How do you calculate free cash flow from revenue?

Answer 4

Revenue
-COGS and operating expenses to get operating income (EBIT)
-CAPEX
+Depreciation and Amortization
- Net increase (or +decrease) in working capital
+All other relevant cash flows
=free cash flow

Question 5

What is net working capital?

Answer 5

Working capital=current assets-current liabilities

A measure of the company’s efficiency and it’s short term financial health

Shows if a company can meet its short term liabilities with its current assets

Question 6

Why do you start with EBIT when calculating free cash flow?

Answer 6

Start with EBIT because you want operating income before you take into account capital structure and taxes
EBIT is unlevered because it doesn’t take into account the capital structure (interest)
We want it to be unlevered because it is levered when we discount it back by WACC (if it were already levered then we would be deducting the cost of edit twice)

Question 7

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

Answer 7

Very high growth firm (start up or tech)

Question 8

What is beta?

Answer 8

Beta is a measure of systematic risk.

The value is based on historical performance, so it’s not always the best indicator for the future

It’s the standardized covariance between market return and the individual security return.

Question 9

What value does DCF give you?

Answer 9

Enterprise Value (EV)

Question 10

If working capital increases, what happens to FCF?

Answer 10

Decrease (see equation)

Question 11

Give me an example of a negative beta

Answer 11

Gold

Question 12

What are two ways to calculate the terminal value?

Answer 12

Gordon growth model

EBITDA multiples

Question 13

Is FCF levered?

Answer 13

No because you don’t include interest expense

Question 14

How would DCF change if you used levered FCF?

Answer 14

You wouldn’t discount by WACC (because it’s levered), instead you would use the cost of equity and the ending would be an equity value instead of EV

Question 15

Why might a company choose debt over equity financing?

Answer 15

Debt is cheaper because interest is tax deductible

They don’t want to dilute ownership share

Question 16

You do a DCF and get an EV of $100. But this company is able to charge higher prices (company premium). Is it safe to add another $10 to the resulting DCF to reflect their premium?

Answer 16

No. The premium is reflected in higher prices, which is reflected in the FCF. So we’ve already included the premium and our EV value is correct.

Question 17

What do you divide EV by to get price per share?

Answer 17

Number of fully diluted shares outstanding

Question 18

What’s the difference between number of fully diluted shares and basic shares?

Answer 18

Basic: number of shares at a given point in time

Fully diluted: share count with the effects of diluted securities taken into account

Question 19

What are diluted securities?

Answer 19

Convertible debt, convertible preferred stock, options, and warrants

Question 20

What CAPEX do you use do FCF?

Answer 20

Maintenance CAPEX because you want to see the FCF in the everyday working of the company. This will be difficult to separate from growth CAPEX because it is not required to be reported separately.

Question 21

How do you calculate FCF from net income?

Answer 21

Add back depreciation and amortization
Subtract change in net working capital
Subtract CAPEX

Note that this levered
To make it unlevered add in interest expense

Question 22

Does a change in net working capital include cash changes?

Answer 22

No. This is meant to show sources of cash that don’t match up the net income figure. An example would be buying inventory. That wouldn’t show up on the Income Statement until you sell it but you used cash and need to recognize it.

Question 23

What’s the formula for WACC?

Answer 23

(%equity)(cost of equity)+(%debt)(cost of debt)(1-t)

Question 24

What does WACC stand for?

Answer 24

Weighted average cost of capital

Question 25

What does CAPM stand for?

Answer 25

Capital assets pricing model

Question 26

How do you calculate the cost of equity?

Answer 26

Use CAPM

Question 27

How do you calculate the cost of debt

Answer 27

Use the yield on the most recent bond issuance

Question 28

How do you calculate CAPM?

Answer 28

(Risk free rate)+(company’s beta)(market risk premium)

Question 29

What is the market risk premium?

Answer 29

Average return on the market-the risk free rate

Question 30

What is the risk free rate?

Answer 30

The yield on a 10-year US government bond

Question 31

How do you calculate the value of a terminal year cash flow?

Answer 31

(WACC)+(growth rate)

Question 32

How could I reduce WACC?

Answer 32

Somehow lower your cost of debt or equity

More likely readjust your capital structure more towards debt (lever up) because the cost of debt is lower

Question 33

Why is the cost of debt lower?

Answer 33

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

Question 34

If you were to graph WACC on the y axis and debt/equity on the x, what would the graph look like?

Answer 34

A “U”

WACC will initially decease as you increase D/E due to the lower cost of debt.

But it will shoot up again due to the riskiness of leverage. This will raise your cost of equity and counteract the advantages of debt.

Question 35

How do you calculate the value of leveraged beta?

Answer 35

Levered beta= (unlevered beta)[1+(1-tax)(debt/equity)]

Unlevered beta= (levered beta)/[1+(1-tax)(debt/equity)]

Question 36

When using CAPM to calculate WACC, why do you have to unlever and then relever beta?

Answer 36

Beta takes each company’s debt into account but not its capital structure. In order to use the beta of a comparable company, you must unlever it. You then relever it with your company’s d/e ratio to get a beta that is accurate for your capital structure.

Question 37

When using CAPM to calculate WACC, what beta do you use?

Answer 37

We typically use an industry beta, which is calculated by taking the mean or median 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 for, you are valuing.

Question 38

Name some non-recurring changes that need to be added back to a company’s EBIT/EBITDA

Answer 38

You want to add back anything that doesn’t represent a common and recurring expense in the operations of a business.

Restructuring charges, goodwill charges, asset write downs, one time legal expenses, disaster expenses, etc