IB Vine DCF

What happens to a company's cost of equity as it takes on more debt?

It rises. More debt increases the company's levered beta, and since beta drives cost of equity, equity holders demand a higher return for the added financial risk.

Which input in the cost of equity calculation transmits the effect of added debt?

Levered beta. Debt does not enter the CAPM formula directly, it raises levered beta, which in turn raises cost of equity.

Why can you not calculate WACC directly for a private company?

There is no market data. No public share price means no market capitalization and no observable beta, and there is usually no traded debt to imply a cost of debt.

How do you estimate the cost of equity for a private company?

Take betas from public comparable companies, unlever them, re-lever at the target's capital structure, then run those through CAPM.

How do you estimate a private company's capital structure for WACC?

Use the median debt to equity ratio of public comparable companies, since the private company's own structure may be temporary or unrepresentative.

How do you estimate the cost of debt for a private company?

Use the yield on debt of comparable public companies with a similar credit profile, or the rate on the company's own recent borrowings.

What does the mid-year convention assume about the timing of cash flows?

That cash flows are generated evenly throughout the year, so on average they arrive at the midpoint, rather than all landing at year end.

How does the mid-year convention change the discount period exponents?

Each period drops by half a year. Year one uses 0.5, year two uses 1.5, year three uses 2.5, and so on.

Why does the mid-year convention increase the value a DCF produces?

Because you discount each cash flow over a shorter period, so each present value is larger. The effect is real but modest.

Under the mid-year convention, what exponent do you use to discount projection period cash flows?

Use n minus 0.5, where n is the year number.

Under the mid-year convention with the exit multiple method, what discount period applies to terminal value?

The full period n, not n minus 0.5, because the sale is assumed to occur at the end of the final year.

Why is terminal value discounted differently from projection cash flows under the mid-year convention?

Because terminal value is a single point in time event, a sale at year end, rather than a stream of cash spread evenly across the year.

How do you handle a six month stub period in a mid-year convention DCF?

Split the initial period out as its own half year and discount it at its own midpoint, which is 0.25 years if the stub is truly mid-quarter.

After a six month stub period, what discount periods do the subsequent full years use?

The midpoint of the first full year is the end of the stub plus half a year, so 1.0, then 2.0, then 3.0, and so on.

What are the two ways to handle a planned Year 3 acquisition in a DCF forecast?

Either model the combined company's free cash flow from Year 3 onward, or keep it simple and show the purchase price as a one-time cash outflow in Year 3.

If you fully model a planned acquisition in a DCF, what do you need to adjust from that year onward?

The combined company's free cash flow, adjusted for synergy assumptions and the purchase price paid.

What is the simplified way to reflect a Year 3 cash acquisition in a DCF, and when does it break down?

Show it as an outflow or a negative capital expenditure line in Year 3. It breaks down when you need real accuracy, where fuller M&A modeling is required.

If you are using levered free cash flow in a DCF, what discount rate do you use?

The cost of equity.

Why is levered free cash flow discounted at the cost of equity rather than WACC?

Because levered free cash flow is what remains after interest and debt service, so it is available only to equity holders, and you discount at their required return.

How do you handle a significant annual debt repayment in a levered DCF model?

Explicitly subtract the mandatory principal repayment in each period, since levered free cash flow is after interest and debt service.

What effect does mandatory principal repayment have on levered free cash flow?

It reduces the free cash flow available to equity holders each year, which lowers the resulting equity value.

Why might a DCF be inaccurate for a cyclical sector like airlines?

Airlines see large swings in revenue and expenses from fuel costs, demand cycles, and labor contracts, so projecting stable growth or margins is not credible.

Why are small assumption errors especially dangerous in a DCF for a cyclical company?

Because the underlying cash flows swing so widely, a small error in a growth or margin assumption compounds across the forecast and can greatly skew the valuation.

Should a mid-year convention DCF produce a much higher value than the standard approach?

No. It should be higher, but only modestly. A dramatic gap is a signal that something is wrong.

If your mid-year convention DCF is dramatically higher than the standard approach, what is likely wrong?

You are probably double counting, or you have applied mid-year discounting to the terminal value when that should receive a full discount period.

When does a Dividend Discount Model make more sense than a standard DCF?

For financial institutions, or for firms that pay a stable dividend closely tied to earnings, such as certain utilities.

Why does standard unlevered free cash flow analysis break down for banks and insurers?

Because their capital structures rely on deposits or insurance float, so debt functions as an operating input rather than as financing, which makes unlevered free cash flow far less meaningful.

How do you calculate terminal value in a Dividend Discount Model?

Apply an appropriate price to earnings multiple to the final projected year's earnings per share, or run a Gordon Growth calculation on dividends.

Two companies are identical except one has convertible debt. Do they have the same enterprise value in a DCF?

On an enterprise value basis they look essentially the same, because the DCF values the operations and the cash flow, WACC, and growth inputs are identical.

Where does convertible debt actually change the outcome of a DCF?

At the equity value and per share level. If the converts are in the money they turn into equity, which raises the share count and changes the value per share.

Does a high beta necessarily mean a higher WACC?

Usually yes, since beta raises cost of equity and cost of equity is a component of WACC. But it is not automatic if the debt weight is large enough to offset it.

Through what channel does beta affect WACC?

Beta feeds into cost of equity through CAPM, and cost of equity is then weighted by the equity portion of the capital structure.

How do you reflect repeated share issuances in a DCF?

Run a levered DCF and factor the new equity issuances into the share count in each year.

If you use unlevered free cash flow despite a rapidly changing capital structure, what do you still have to track?

Changes that affect WACC and net debt. More advanced models recalculate WACC each year rather than holding a single rate constant.

How do you treat amortization of intangible assets in a DCF?

Add it back as a non-cash expense, since it reduces EBIT but does not consume cash.

What is the trap when adding back intangible amortization in a DCF?

Real cash costs to maintain or renew those intangibles may not appear as standard capital expenditure, so simply adding back amortization can overstate free cash flow.

Name three reasons your DCF might imply a value far below a public company's current share price.

Your forecasts were overly conservative, your discount rate was too high, or the market is pricing in intangible positives and synergy prospects your model does not capture.

Besides model error, what is the other explanation for a DCF value far below the market price?

The stock may simply be overvalued, at least from a pure fundamental standpoint.

Why do you unlever the betas of comparable companies?

Because each comparable has its own capital structure, and unlevering strips out the effect of that leverage to leave the underlying business risk.

Why do you re-lever beta after unlevering comparable company betas?

To apply your target company's own capital structure, so the resulting beta reflects the target's specific financial risk profile.

How are capital leases treated in the WACC calculation?

Like debt, which increases the debt weight in the capital structure and can therefore affect WACC.

How are operating leases treated in the WACC calculation under current accounting standards?

They now appear on the balance sheet as lease liabilities, so they are also treated as debt-like for WACC purposes.

Does a 3 percent terminal growth rate mathematically imply infinite expansion?

Yes. A 3 percent growth rate into perpetuity means the company is assumed to grow forever.

If terminal growth mathematically implies infinite expansion, why is it acceptable?

Because we keep the rate modest, near GDP growth or inflation, which prevents the perpetuity from generating unrealistically large values.

Can you use a negative growth rate in a terminal value calculation?

Technically yes. If cash flows are expected to shrink perpetually, you can model a small negative rate.

What is the danger of applying a negative perpetual growth rate?

Negative indefinite growth implies the business eventually goes to zero, which is often not the intended assumption, so it must be used cautiously.

Do you present a DCF valuation as a single figure or a range?

As a range. You rarely rely on a single number.

What do you sensitize to build a DCF valuation range?

The discount rate and the terminal multiple or terminal growth rate, laid out in sensitivity tables.

What scenarios do you typically present alongside a DCF valuation range?

A best case, a base case, and a worst case.

Name the three places taxes affect a DCF.

Calculating beta, when you convert from unlevered to levered. Calculating free cash flow, through NOPAT. And calculating the cost of debt, since interest is tax deductible.

How do taxes enter the beta calculation in a DCF?

Through the unlevering and relevering formula, where the tax rate scales the debt to equity adjustment applied to beta.

How do taxes enter the free cash flow calculation in a DCF?

Through NOPAT. You tax EBIT to get net operating profit after tax before adding back non-cash charges.

How do taxes enter the cost of debt in a DCF?

Interest is tax deductible, so you use the after-tax cost of debt, which is the pre-tax cost of debt multiplied by one minus the tax rate.

For a coal mine company, would you use Gordon Growth or the Multiples Method for terminal value?

The multiples method.

Why is Gordon Growth the wrong terminal value method for a coal mine?

Because Gordon Growth assumes cash flows continue into perpetuity, and coal is a depleting resource, so the asset has a finite life.

Name the three adjustments you would make to a DCF for a highly speculative technology company.

A longer projection horizon, a higher discount rate, and growth and margin assumptions adjusted for uncertainty.

Why would you extend the projection horizon for a speculative technology company?

Because it may take far longer for the business to stabilize, so a standard five year window would end before the company reaches a steady state.

Why would you raise the discount rate for a speculative technology company?

To reflect the higher risk of the cash flows, since the required return investors demand goes up with uncertainty.

A company buys a factory for $100 in Year 4. How does that affect the DCF?

You add $100 of capital expenditure in Year 4, which reduces that year's free cash flow by $100 and lowers enterprise value by the present value of that $100.

A company buys a factory for $100 in Year 4. How much does enterprise value fall?

By the present value of the outflow, which is 100 divided by one plus r, raised to the fourth power.

How do you choose a long-term growth rate for the Gordon Growth Method?

Pick a conservative rate anchored to inflation or long-run GDP growth, typically around 2 to 3 percent.

What long-term growth rate would be considered aggressive in a developed market?

Anything above 5 percent.

Name the three ways that lowering the tax rate affects a DCF valuation.

It boosts net income and therefore free cash flow, it raises the after-tax cost of debt because the tax shield shrinks, and it raises cost of equity through the levered beta calculation.

Why does lowering the tax rate raise the after-tax cost of debt?

Because the interest tax shield is worth less. A lower tax rate means less of the interest expense is deductible, so the after-tax cost of debt rises toward the pre-tax cost.

Why does lowering the tax rate raise the cost of equity?

Because the tax term in the levered beta formula shrinks, which raises levered beta, and a higher beta feeds through CAPM into a higher cost of equity.

When the tax rate falls, is the net effect on DCF value positive or negative?

It depends on which force is stronger, the increase in free cash flow or the increase in WACC. Both move in opposite directions on value.

Name three common alterations to the basic WACC formula that make it more company-specific.

Add a size premium or liquidity discount for smaller or private entities, include preferred stock if it is part of the capital structure, and use an alternative cost of equity approach if beta is unusable.

Why would you add a size premium to WACC?

Because smaller and private entities carry additional risk and illiquidity that a beta derived from large public comparables does not capture.

When do you need to add a third term to the WACC formula?

When preferred stock is part of the capital structure, it gets its own weight and its own cost alongside debt and equity.

Ignoring taxes, how does switching from LIFO to FIFO affect free cash flow during a period of rising costs?

In a simplified scenario it is neutral. Free cash flow does not change.

Ignoring taxes, why is the free cash flow effect of a LIFO to FIFO switch neutral in rising costs?

FIFO lowers cost of goods sold, which raises net income, but it also raises the inventory balance, which is a use of cash. The two effects offset.

In a DCF, which increases valuation most: a $10 decrease in capital expenditures, a $10 decrease in expenses, or a $10 increase in revenue?

The $10 decrease in capital expenditures.

Why does a $10 decrease in capital expenditures beat a $10 decrease in expenses in a DCF?

Because capital expenditure sits below the tax line, so cutting it adds the full $10 to free cash flow. Cutting expenses adds only $10 times one minus the tax rate.

By how much does a $10 increase in revenue raise free cash flow?

By $10 multiplied by one minus the tax rate, because the incremental revenue flows through the income statement and gets taxed.

What is asset beta?

Asset beta, also called unlevered beta, measures a company's underlying business risk with the effect of debt stripped out.

What is equity beta?

Equity beta, also called levered beta, measures risk including the effect of debt, which makes it higher than asset beta whenever leverage exists.

What is the difference between asset beta and equity beta?

Asset beta is unlevered and captures business risk only. Equity beta is levered and adds financial risk from debt, so it is the higher of the two for any levered company.

How does raising $100 million of debt in Year 3 affect unlevered free cash flow?

It does not. Unlevered free cash flow is calculated before interest, so new interest costs do not touch it.

How does raising $100 million of debt in Year 3 affect a DCF valuation?

It changes the capital structure from Year 3 onward, which can alter WACC. You may recalculate WACC after Year 3 and discount from that point at the new rate.

What is maintenance capital expenditure?

The baseline amount of spending required simply to sustain existing operations at their current level.

What is growth capital expenditure?

Spending that supports expansion into new products or markets, and it can often be deferred if the company needs to preserve cash.

What is acquisition capital expenditure?

Funding deployed for mergers and acquisitions activity rather than for organic operations.

Which category of capital expenditure matters most when valuing a company, and why?

Maintenance capital expenditure, because it is mandatory. It must be subtracted from operating cash flow, whereas growth and acquisition spending are more discretionary.

What is cheaper, debt or equity?

Debt.

Why is debt cheaper than equity?

Interest is tax deductible, which lowers the effective cost, and debt sits above equity in the capital structure, so debt holders take less risk and demand a lower return.

Within WACC, can the cost of debt ever exceed the cost of equity?

Typically no.

Why does the cost of debt normally stay below the cost of equity?

Because debt ranks above equity in the capital structure, so debt holders bear less risk and require a lower return.

In extreme distress, can debt yields exceed the cost of equity?

Debt yields can spike sharply in distress, but rational equity investors would still demand a higher return than debt holders, since equity remains the more junior claim.

If an asset on the balance sheet decreases, what happens to free cash flow?

Free cash flow rises. A decrease in an asset means a smaller change in net working capital, which is a source of cash.

If an asset on the balance sheet increases, what happens to free cash flow?

Free cash flow falls. An increase in an asset means a larger change in net working capital, which is a use of cash.

How do you calculate the stub period length for a mid-year convention DCF?

Count the months remaining until December 31 and divide by 12. A valuation dated at the end of Q1 gives a 0.75 year stub, end of Q2 gives 0.5, end of Q3 gives 0.25, end of Q4 gives zero.

Under the mid-year convention, what exponent discounts the stub period cash flow?

Half the stub length, or s divided by 2.

Under the mid-year convention, what exponent discounts the first full year after a stub?

The stub length plus 0.5, because that cash flow arrives six months into the following year.

Under the mid-year convention with a stub, how do you get each subsequent year's discount exponent?

Add 1.0 to the previous year's exponent, since each midpoint sits exactly one year later.

Valuing at the end of Q1 with the mid-year convention, what are the stub and first full year discount exponents?

The stub uses 0.375 and the first full year uses 1.25.

Valuing at the end of Q2 with the mid-year convention, what are the stub and first full year discount exponents?

The stub uses 0.25 and the first full year uses 1.0.

Valuing at the end of Q3 with the mid-year convention, what are the stub and first full year discount exponents?

The stub uses 0.125 and the first full year uses 0.75.

Valuing at the end of Q4 with the mid-year convention, what are the first two discount exponents?

There is no stub, so you use 0.5 and then 1.5, which is the standard mid-year pattern.

One company runs net working capital at 11 percent of sales, another at 12 percent. If sales are rising, which is valued higher?

The company at 11 percent.

Why does a lower net working capital to sales ratio produce a higher valuation when sales are growing?

Because it ties up less cash in working capital for every dollar of sales growth, so more of the growth converts into free cash flow.