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P&R DCF > P&R DCF > Flashcards

P&R DCF Flashcards

1
Q

How do we define the value of a company?

A

“The value of a company, division, business, or collection of assets can be derived from the present value of its projected Free Cash Flow” P&R pg. 109

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2
Q

What are two potential problems with relative/market-based valuation? What is our biggest challenge in performing a DCF valuation?

A

Relative/market-based: lack of pure-play comparables, market distortions (i.e. mispricing)DCF: The entire analysis depends on our assumptions!P&R pg. 110

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3
Q

What are the major steps in a DCF analysis?

A

• Step I: Study the Target and Determine its Key Performance Divers• Step II: Project Free Cash Flow During the Projection Periodo Normalize and analyze historical financials as a basis for projection• Step II: Calculate the Weighted Average Cost of Capital (WACC)• Step IV: Determine Terminal Value• Step V: Calculate Present Value and Determine ValuationP&R pg. 110

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4
Q

Do we project levered FCF or unlevered FCF in a DCF analysis?

A

Unlevered FCFP&R pg. 110

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5
Q

What determines the length of our projection period?

A

Long enough that the target’s financial performance is deemed to have reached a “steady state” that can serve as the basis for a terminal value calculationP&R pg. 111

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6
Q

What is the most common projection period used?

A

5 years P&R pg. 115-116

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7
Q

Name two cases when we might use a longer projection period…

A

1) In situations where the target is in the early stages of rapid growth, it make take 10+ years for the target to reach a steady state level of cash flow2) For businesses in sectors with long-term, contracted revenue streams (e.g. natural resources, satellite communications, utilities)P&R pg. 116

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8
Q

What are two alternative names for WACC?

A

Weighted average cost of capital, cost of capital, discount rateP&R pg. 111

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9
Q

State the formula for Unlevered Free Cash Flow calculation…

A

P&R pg. 115

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10
Q

State two alternative names for EBIAT:

A

NOPAT (Net Operating Profit After Taxes) and Tax-effected EBIT P&R pg. 119

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11
Q

What is the formula for EBIAT?

A

EBIAT = EBIT × (1 – t) , where “t” is the target’s marginal tax rateP&R pg. 119

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12
Q

Name three reasons why a company’s effective tax rate may differ from its marginal tax rate

A

1) Tax credits2) Non-deductible expenses3) Deferred tax asset valuation allowancesP&R pg. 119

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13
Q

What type of intangibles are amortized?

A

Definite life intangible assets are amortized P&R pg. 119

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14
Q

What should the relationship between CapEx and D&A be in our steady-state final year?

A

“… the banker often makes a simplifying assumption that depreciation and CapEx are in line by the final year of the projection period… to ensure that the company’s PP&E base remains steady in perpetuity. Otherwise, the company’s valuation would be influenced by an expanding or diminishing PP&E base, which would not be representative of a steady state business” P&R pg. 120

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15
Q

Define Net Working Capital:

A

“Non-cash current assets less non-interest-bearing current liabilities” P&R pg. 121

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16
Q

Define “Days Sales Outstanding” (DSO):

A

Source: P&R pg. 122

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17
Q

What does the DSO number represent conceptually?

A

It measures the number of days it takes to collect payment after the sale of a product or service P&R pg. 122

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18
Q

Define “Days Inventory Held” (DIH):

A
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19
Q

What does DIH measure conceptually?

A

It measures the number of days that it takes for the company to turn its inventory P&R pg. 123

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20
Q

What is an alternative to DIH that also measures inventory efficiency? What is the relationship between the two ratios?

A

DIH is the inverse of Inventory Turns, multiplied by 365. So if DIH is 90 = 1/4 × 365, turns is 4.

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21
Q

Define Days Payable Outstanding (DPO):

A
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22
Q

What does DPO measure conceptually?

A

DPO measures the number of days that it takes for the company to make payment on its purchases from suppliers. P&R pg. 124

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23
Q

Give three definitions for WACC:

A

1) WACC is the discount rate the present value of a company’s projected FCF and terminal value2) WACC represents the (weighted average of the) required return on the invested capita in a given company3) WACC can also be thought of as an opportunity cost of capital, or what an investor would expect to earn in an alternative investment with a similar risk profileSource: P&R pg. 24

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24
Q

How might we value a company with diverse business segments?

A

Such a company may have a different cost of capital for each segment, so we may choose a “sum of the parts approach” in which a separate DCF analysis is performed for each distinct business segment, each with its own WACC. The values of each business segment are then summed to determine the enterprise value of the company.Source: P&R pg. 125

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25
Q

State the formula for Weighted-Average Cost of Capital (WACC):

A

P&R pg. 125

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26
Q

Discuss the steps for Calculating WACC:

A

1) Determine Target Capital Structure (pg. 125 – 126):a. Defined as % Debt (D/(D+E)) and % Equity (E/(D+E))b. For public companies: Generally use existing capital structure. If the existing structure is significantly different from comparables, we may use the mean or median of the comparables.c. For private companies: Generally we use the mean or median of public comparables2) Estimate Cost of Debt3) Estimate the Cost of Equity4) Calculate WACCSource: P&R pg. 125

27
Q

What is the “optimal capital structure”?

A

The financing mix that minimizes WACC, thereby maximizing a company’s theoretical valueSource: P&R pg. 126

28
Q

Discuss how adding debt to a company’s capital structure impacts WACC:

A

With no debt in the capital structure, WACC is equal to the cost of equity. As the proportion of debt increases, WACC decreases due to the tax deductibility of interest expense. There comes a point where the risk from additional debt overrides the tax benefits (debt becomes more expensive as it becomes riskier) and the WACC begins rising again. The minimum point is called the optimal capital structure.Source: P&R pg. 126

29
Q

Which is readily observable in the market – cost of equity or cost of debt?

A

Cost of debt is readily observable if the debt is publicly traded. Cost of equity is not and we must use CAPM.Source: P&R pg. 127

30
Q

How do we estimate the cost of debt?

A

• If the company is 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”o PREFERRED: Publicly traded bonds: Cost of debt is determined based on the current yield of all outstanding issues Private debt: Consult with an in-house DCM specialist to ascertain the current yieldo SECOND BEST: Approximate the company’s cost of debt based on its current credit ratings and the cost of debt for comparable credits (usually assisted by DCM professional)o THIRD BEST: In the absence of current market data, we can calculate the company’s cost of debt on the basis of the at-issuance coupons of its current debt maturities (note this is back-ward look)In the event the company is not currently at its target capital structure, the cost of debt must be derived from peer companies (using the approaches described above)

31
Q

At what tax rate is the cost of debt tax affected?

A

The marginal tax rateSource: P&R pg. 127

32
Q

How is current yield calculated for a) a vanilla bond and b) a callable bond?

A

Vanilla bond: Current Yield = Annual Coupon / Current Price of BondCallable bond: Typically quoted at yield-to-worst call (YTW). Calculate by looking at the call schedule, and finding the worst yield as defined by Call Price / (Current Price OR Initial Offer Price)Source: P&R pg. 127

33
Q

What pricing model do we use to calculate the expected return on a company’s equity? What is the theory behind this model?

A

CAPM – Based on the premise that equity investors need to be compensate for their assumption of systematic risk in the form of a risk premium. Equity investors are not compensated for company-specific risk via a premium because it can be avoided through diversification.P&R pg. 127 - 128

34
Q

What does Beta measure?

A

“The covariance between the rate of return on a company’s stock and the overall market return (with the S&P 500 used as a traditional proxy for the market”P&R pg. 129

35
Q

What is the market Beta?

A

1.0 P&R pg. 129

36
Q

State the CAPM formula:

A
37
Q

What are two common securities uses to determine the risk-free rate?

A

10-year US Treasury NoteIbbotson Associates uses an interpolated yield for a 20 year US Treasury bond

38
Q

Why do we use a long-dated security for the risk free rate?

A

To match the expected life of the company P&R pg. 128

39
Q

What is a T-Bill?

A

“Non-interest-bearing securities issued with maturities of 3 months, 6 months and 12 months at a discount to face value”P&R pg. 128 footnote

40
Q

What is a T-Note?

A

“A US government security with a maturity of between one and ten years that pays a semi-annual coupon” P&R pg. 128 footnote

41
Q

What is a T-Bond?

A

“A US government security with a maturity of greater than ten years that pays a semi-annual coupon” P&R pg. 128 footnote

42
Q

Define the Market Risk Premium… Is there a standard across all banks/time period? What is a typical range? What is Ibbotson’s number for the 1926 to 2007 period?

A

“The market risk premium is the spread of the expected market return over the risk-free rate”Banks and academics may use their own time standards and may use different time periods“The equity risk premium employed on Wall Street typically ranges from 4% to 8%”“For the 1926 to 2007 period, Ibbotson calculates a market risk premium of 7.1%”

43
Q

What are two types of Beta that may be used?

A

Historical beta or predicted beta (provided by MSCI Barra).P&R Pg. 129

44
Q

How do we calculate cost of equity for a private company?

A

Still use the CAPM P&R pg. 130

45
Q

How do we calculate Beta for a private company?

A

We 1) select a publicly traded peer group, 2) unlever the beta for each company in the peer group to achieve an unlevered/asset beta, 3) Determine the average unlevered/asset beta (this may be done on a market-cap weighted basis) and 4) relever the beta using the company’s target capital structure and marginal tax rateP&R pg. 130

46
Q

State the formula for unlevering Beta

A

P&R pg. 130

47
Q

State the formula for relevering Beta

A

P&R pg. 130

48
Q

What is one common adjustment to the CAPM formula? Why is it made?

A

We may add a size premium. This is “based on empirical evidence suggesting that smaller sized companies are riskier and, therefore, should have a higher cost of equity”P&R pg. 131

49
Q

How much of a company’s total value may the terminal value account for?

A

“Up to 75% or more”P&R pg. 131

50
Q

What is one common adjustment to the CAPM formula? Why is it made?

A

We may add a size premium. This is “based on empirical evidence suggesting that smaller sized companies are riskier and, therefore, should have a higher cost of equity”P&R pg. 131

51
Q

Why must be pay special attention to the final year of projections?

A

Since the terminal value calculation is driven by final year FCF or EBITDA, “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”P&R pg. 131

52
Q

What are the two primary methods for calculating terminal value?

A

Exit Multiple Method and Perpetuity Growth MethodP&R pg. 132

53
Q

State the formula for Exit Multiple Method terminal value

A

P&R pg. 132

54
Q

State the formula for Exit Multiple Method terminal value

A

P&R pg. 132

55
Q

Exit Multiple Method: What year of EBITDA is used? How do we calculate the Exit Multiple?

A

EBITDA from the final year of the projection.“The Exit Multiple is typically based on LTM trading multiples for comparable companies”Source: P&R pg. 132

56
Q

Why must we be careful in selecting an Exit Multiple?

A

“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/trough multiple and/or an un-normalized EBITDA level can produce a skewed result. This is especially important for companies in cyclical industries”Source: P&R pg. 132

57
Q

How does the Perpetuity Growth Method work? State the appropriate formula

A

“The PGM calculates terminal value by treating a company’s terminal year FCF as a perpetuity growing at a constant rate”P&R pg. 132-133

58
Q

What is a typical perpetuity growth rate based on? What is a typical range?

A

“The perpetuity growth rate is typically chosen on the basis of the company’s long-term industry growth rate… which generally tends to be within a range of 2% to 4% (i.e. normal GDP growth”P&R pg. 133

59
Q

State the formula that calculates implied perpetuity growth rate with a) end of year discounting and b) mid-year discounting

A

P&R pg. 133

60
Q

State the formula that calculates implied exit multiple with a) end of year discounting and b) mid-year discounting

A

P&R pg. 133

61
Q

State the a) discount factor and b) mid-year adjustment factor for the stub year

A

Source: WSP pg. 34 & 37

62
Q

State the a) discount factor and b) mid-year adjustment factor for the projection period

A

Source: WSP pg. 35 & 38

63
Q

xWhy do we use a mid-year convention? Is the valuation higher using a mid-year convention or end of year discount?

A

We use a mid-year convention because it better approximates the cash flows being received evenly throughout the year. The mid-year convention results in a slightly higher value than end-of-year discounting because we receive the cash sooner P&R pg. 134-135

64
Q

What kind of discounting (mid-year or end of year) does the PGM use? How about the EMM? How do we implement this in practice?

A

The PGM uses mid-year discounting, the EMM uses end of year discountingMultiply PGM by the last year’s discount factor and mid-year adjustment factor. Multiply EMM only by the last year’s discount factor.P&R pg. 135

P&R DCF (1 decks)

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