Basic - DCF Flashcards

Question

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

Answer 1

* 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 of 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 as follows: * Unlevered Beta = Levered Beta / (1 + [(1 - Tax Rate) x (Total Debt/Equity)]) * Levered Beta = Unlevered Beta * (1 + [(1 - Tax Rate) x (Total Debt/Equity)])

Answer 2

* When you look up the Betas on Bloomberg (or whatever source you're using) they will already be levered b/c 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. * But at the end of the calculation, we need to re-lever the median Unlevered Beta of that set b/c 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.

Answer 3

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

Answer 4

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

Answer 5

* 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 asset 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.

Answer 6

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

Answer 7

* 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.

Answer 8

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 * Beta formula to estimate the company's expected return instead.

Answer 9

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.

Answer 10

* 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 b/c 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 b/c 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.

Answer 11

* 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. Then, think about the individual components of Cost of Equity: the Risk-Free Rate, the Equity Risk Premium & Beta. * The Risk-Free Rate would decrease b/c governments worldwide would drop interest rates to encourage spending; but then Equity Risk Premium would also 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 b/c 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 b/c almost all these variables push it up - the only 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 a higher rates, so WACC must have increased.

Answer 12

* You can either apply an exit multiple to the company's Year 5 EBITDA, EBIT, or FCF (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 FCF * (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 FCF from the final year into infinity, as of the final year.

Answer 13

* 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 rate rather than exit multiples.

Answer 14

* 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.

Answer 15

* 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.

Answer 16

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

Answer 17

* Terminal Value = Final Year FCF * (1 + Growth Rate) / (Discount Rate - Growth Rate) * 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 we can "afford" to pay $1000 now ($100/10%) to receive $100 in Year 1 and $100 in every year after that forever. * But now let's say that the stream of $100 were actually growing each year - if that's the case, then we could afford to invest more than the initial $1000. * 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 the same 10% return. We can estimate the $100 by (10% - 5%). 10% is our required return and 5% is the growth rate. So in this case, $100 / (10% - 5%) = $2000. * This corresponds to the formula above: $100 represents Final Year FCF * (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.

Answer 18

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.

Answer 19

* 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 FCFs 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.

Answer 20

* 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.

Answer 21

* 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.

Answer 22

Company A b/c 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.

Answer 23

It should be higher for the $500M company, because all else being equal, smaller companies are expected to outperform large companies in the stock market (and are therefore "riskier").

Answer 24

* This is a bit of a trick question b/c 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 $500M company for the same reasons stated 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.

Answer 25

More Debt means that the company is riskier, so the company's Leveraged Beta will be higher - so all else being equal, Cost of Equity would increase. Less Debt would decrease Cost of Equity.

Answer 26

The one without Debt will generally have a higher WACC b/c Debt is "less expensive" than Equity. Why? • Interest on Debt is tax-deductible - hence the (1 - Tax Rate) multiplication in the WACC formula. • Debt is senior to Equity in a company's capital structure - debt investors would be paid first in a liquidation or bankruptcy scenario. • 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.

Answer 27

* The one w/o Debt is not "at a disadvantage" - but it won't be valued as highly b/c of the way the WACC formula works. * Keep in mind that companies do not make big decisions based on 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.

Answer 28

The Discount Rate change will almost certainly have a bigger impact b/c that affects everything from the present value of FCFs to the present value of Terminal Value - and even a 10% change makes a huge impact.

Answer 29

In this case, the change in Revenue is likely to have a bigger impact b/c you've change 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 FCFs.

Answer 30

A percentage that's less than 10%, for two reasons: 1. Remember that we discount all those FCFs - 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.

Answer 31

``` Common Sensitivities: • Revenue Growth vs. Terminal Multiple • EBITDA Margin vs. Terminal Multiple • Terminal Multiple vs. Discount Rate • Terminal Growth Rate vs. Discount Rate ```

Answer 32

* Trick question. You don't account for this at all in an Unlevered DCF b/c 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 FCF 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 b/c Levered FCF will be lower each year.

Answer 33

* It's always better to pay the bare minimum. 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 $1000 in debt. * Initially, it pays $100 in Interest Expense, and after taxes that's only $60 [$100 * (1 - 40%)]. So Levered FCF 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 FCF is down by at least $200 each year, and the company still pays interest, albeit lower interest, until the end of the period. * So the company is always better off, valuation-wise, waiting as long as possible to repay Debt.

Basic - DCF Flashcards

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