Discounted Cash Flow Analysis - Enterprise Value 1-10

What does a DCF model value a business based on?

True cash flow rather than accrual-based Net Income.

What is the Free Cash Flow formula?

Net Income + Depreciation/Stock Comp - CapEx ± Change in Working Capital + After-Tax Interest Cost.

Why are depreciation and stock-based compensation added back to Net Income?

They are non-cash expenses and do not represent actual cash leaving the bank.

Why is after-tax interest added back to Net Income in FCF?

Interest is a financing expense, not an operating cash outflow.

What is the formula for After-Tax Interest Cost?

Annual Interest Expense × (1 - Corporate Tax Rate).

What happens to cash flow when Accounts Receivable increases?

Cash flow decreases because revenue was recorded but cash has not been collected.

What happens to cash flow when Accounts Receivable decreases?

Cash flow increases because prior invoices were collected.

What happens to cash flow when Inventory increases?

Cash flow decreases because cash was spent on goods not yet sold or expensed.

What happens to cash flow when Inventory decreases?

Cash flow increases because products were sold without a new cash outlay.

What happens to cash flow when Accounts Payable increases?

Cash flow increases because expenses were recorded but vendors have not been paid.

What happens to cash flow when Accounts Payable decreases?

Cash flow decreases because cash is used to pay prior vendor invoices.

What is the key working capital rule?

An increase in a current asset drains cash, while an increase in a current liability conserves cash.

What is CapEx?

Purchases of long-term physical property, plant, equipment, or machinery needed for operations.

How does CapEx affect FCF?

CapEx is subtracted because it is a direct cash outflow.

Why does CapEx not immediately appear as an expense on the Income Statement?

The asset is capitalized and depreciation is recognized over time.

Why is Terminal Value used in a DCF?

It captures the value of cash flows beyond the detailed forecast period.

Why is Terminal Value needed after Year 5?

Forecasting individual annual cash flows indefinitely becomes too speculative.

What does Terminal Value capture?

The value of cash flows from Year 5 through infinity.

What is the Perpetual Growth Model formula for Terminal Value?

Year 5 FCF × (1 + g) / (WACC - g).

What does C1 represent in the Terminal Value formula?

The projected cash flow in the first year after the forecast period, or Year 6 FCF.

What does r represent in the Terminal Value formula?

The WACC or discount rate.

What does g represent in the Terminal Value formula?

The projected perpetual long-term growth rate of cash flows.

What is the typical perpetual growth rate range?

Approximately 2% to 5%.

What is WACC?

The overall required rate of return across equity, debt, and preferred shares.

What does WACC represent?

The minimum return a firm must generate on its capital investments.

What two major costs are used in WACC?

After-tax cost of debt and cost of equity.

What is the after-tax cost of debt formula?

Interest Rate × (1 - Tax Rate).

What is the CAPM cost of equity formula?

Risk-Free Rate + (Beta × Market Risk Premium).

What happens to WACC when benchmark interest rates rise?

WACC increases.

What happens to WACC when benchmark interest rates fall?

WACC decreases.

What happens to WACC when stock Beta increases?

WACC increases because business risk is higher.

What happens to WACC when stock Beta decreases?

WACC decreases because the business is more stable.

What happens to WACC when a company uses more expensive equity financing?

WACC increases.

What happens to WACC when a company adds cheaper after-tax debt?

WACC decreases.

What happens to Enterprise Value when WACC increases?

Enterprise Value decreases.

What happens to Enterprise Value when WACC decreases?

Enterprise Value increases.

Why does higher WACC lower Enterprise Value?

Future cash flows are discounted at a higher rate, reducing their present value.

What is the Present Value formula?

Undiscounted Cash Flow / (1 + WACC)^5

How are Years 1 through 5 FCFs treated in a DCF?

Each annual forecast cash flow is discounted individually.

How is Terminal Value treated in a DCF?

It is discounted back to Present Value using n = 5.

How do you calculate Total Present Value of Cash Flows?

Add the PV of Years 1–5 FCFs to the PV of Terminal Value.

What is the Enterprise Value bridge formula?

Total PV of Cash Flows - Total Debt + Cash.

Why is debt subtracted when calculating Enterprise Value?

Debt is a liability the buyer must satisfy.

Why is cash added when calculating Enterprise Value?

The cash acquired comes with the business.

What happens to Enterprise Value when revenue growth increases?

Enterprise Value increases.

What happens to Enterprise Value when operating margins expand?

Enterprise Value increases.

What happens to Enterprise Value when WACC increases?

Enterprise Value decreases.

What happens to Enterprise Value when perpetual growth increases?

Enterprise Value increases.

What happens to Enterprise Value when CapEx requirements increase?

Enterprise Value decreases.

What happens to Enterprise Value when working capital is drained by inventory or A/R buildup?

Enterprise Value decreases.

What happens to Enterprise Value when existing debt increases?

Enterprise Value decreases.

What happens to Enterprise Value when current cash increases?

Enterprise Value increases.

What is the primary strength of DCF valuation?

It evaluates intrinsic cash-generating capability independently of temporary market moods or bubbles.

What is the primary limitation of DCF valuation?

It is highly sensitive to changes in multi-year forecasts, Terminal Value, and WACC assumptions.

What is the primary strength of relative valuation?

It is faster, requires fewer assumptions, and reflects real market transaction pricing.

What is the primary limitation of relative valuation?

It can be mispriced if the peer group is inappropriate or the market is in a bubble.

Why do analysts use DCF and relative valuation together in M&A?

DCF determines intrinsic value while relative valuation helps estimate the market purchase price.

What does DCF determine in an M&A transaction?

What the target company is worth to the buyer, including expected synergies.

What does relative valuation and premium analysis determine?

What the buyer will likely have to pay in the market.

What premium is commonly considered in the M&A market price analysis?

Approximately 30%–40%.

When is an M&A deal undervalued or financially feasible?

When the buyer's DCF value including synergies is greater than the market purchase price.

When is an M&A deal overvalued or financially unfeasible?

When the buyer's DCF value is lower than the required market purchase price.

What should a buyer do if DCF value is greater than the purchase price?

The acquisition creates value and makes financial sense.

What should a buyer do if DCF value is lower than the purchase price?

The target is overvalued and the deal should be rejected.