Investment Banking DCF Questions

What's the basic concept behind a Discounted Cash Flow analysis?

We use the free cash flow a company generates in the future to discount them to the present value.

Walk me through a DCF.

First, you do revenue, margin, expense, BS and CFS item projections for a company. And then you derive the free cash flow for a firm for the projected years.

You discount the projected free cash flow to its NPV. And then you determine the terminal value of the company and discount it to present day.

Add them up you get the company's enterprise value.

Walk me through how you get from Revenue to Free Cash Flow in the projections.

UFCF: Revenue - COGS - Opex = EBIT

EBIT*(1-tax rate) + Non-cash Charges + D&A - Change in operating working capital - Capex

LFCF: (EBIT-interest)* ~ - debt repayment

What's the point of Free Cash Flow, anyway? What are you trying to do?

to only include recurring and predictable items from cash flow statement, or even debt

Why do you use 5 or 10 years for the "near future" DCF projections?

Because less then 5 years doesn't really represent a lot, and more than 10 years is too much uncertainty.

Is there a valid reason why we might sometimes project 10 years or more anyway?

Cyclical industry

What do you usually use for the Discount Rate?

UFCF: WAAC

LFCF: Cost of Equity

If I'm working with a public company in a DCF, how do I move from Enterprise Value to its Implied per Share Value?

+cash - preferred stock - NCI - debt / diluted share account

Let's say we do this and find that the Implied per Share Value is $10.00. The company's current share price is $5.00. What does this mean?

doesn't mean anything. you need to run sensitivity check, if it's the case in all scenarios then prob undervalued.

An alternative to the DCF is the Dividend Discount Model (DDM). How is it different in the general case (i.e. for a normal company, not a commercial bank or insurance firm?)

You do not calculate cash flow. Net Income and assume that Dividends Issued are a percentage of Net Income, and then you discount those Dividends back to their present value using the Cost of Equity.

And then you do the same thing as a DCF model, where you eventually derive the terminal value with P/E multiple.

Let's talk more about how you calculate Free Cash Flow. Is it always correct to leave out most of the Cash Flow from Investing section and all of the Cash Flow from Financing section?

yes, unless it's recurring.

Why do you add back non-cash charges when calculating Free Cash Flow?

Because we need to demonstrate how much tax we saved but not from real cash expenses.

As an approximation, do you think it's OK to use EBITDA - Changes in Operating Assets and Liabilities - CapEx to approximate Unlevered Free Cash Flow?

No, because it excludes taxes.

What's the point of that "Changes in Operating Assets and Liabilities" section? What does it mean?

It means if asset growth speed > liabilities, it will decrease cash flow

<, increase cash flow

What happens in the DCF if Free Cash Flow is negative? What if EBIT is negative?

It doesn't change, if future cash flow turns positive it will be adjusted. but if it continues to be negative then it is what it is, you might consider skipping DCF.

Let's say that you use Levered Free Cash Flow rather than Unlevered Free Cash Flow in your DCF - what changes?

U get equity value instead of enterprise value

If you use Levered Free Cash Flow, what should you use as the Discount Rate?

cost of equity

Let's say that you use Unlevered Free Cash Flow in a DCF to calculate Enterprise Value. Then, you work backwards and use the company's Cash, Debt, and so on to calculate its implied Equity Value.

Then you run the analysis using Levered Free Cash Flow instead and calculate Equity Value at the end. Will the implied Equity Value from both these analyses by the same?

They would be different, because in LFCF debt will always impact FCF, unlike UFCF, debt sis a one-time number.

How do you calculate WACC?

cost of equity%equity + cost of debt %debt + cost of preferred stock*%preferred stock

How do you calculate Cost of Equity?

risk free rate of return (10-year treasury bond) + market risk premium (Ibbotson's.) * beta

# Cost of Equity tells us the return that an equity investor might expect for investing in a given company - but what about dividends? Shouldn't we factor dividend yield into the formula?

dividends are already factored into the beta,because Beta describes returns in excess of the market as a whole

# How can we calculate Cost of Equity WITHOUT using CAPM?

(Dividends per Share / Share Price) + Growth Rate of Dividends

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

Median of comparable companies, unlever it, reliever it with capital structure.

Unlevered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Total Debt/Equity)))

Why do you have to un-lever and re-lever Beta when you calculate it based on the comps?

Because a companies capital structure determines how much return/risk it is embedded with.

Wait a second, would you still use Levered Beta with Unlevered Free Cash Flow? What's the deal with that?

They are not the same concept. Levered Beta represents the risk created by debt, UFCF represents the exclusion of debt payment.

How do you treat Preferred Stock in the formulas above for Beta?

consider them as the same with cost of equity

Can Beta ever be negative? What would that mean?

Can, but very rarely. It would mean that the stock performance is opposite against the market. It might happen in a cynical industry.

Would you expect a manufacturing company or a technology company to have a higher Beta?

Tech. Because of higher risk.

Shouldn't you use a company's targeted capital structure rather than its current capital structure when calculating Beta and the Discount Rate?

That's true. We should try to run the sensitivity analysis to derive the lowest discount rate possible. But again. it's very hard. Because you will always end up with 100% debt

The "cost" of Debt and Preferred Stock make intuitive sense because the company is paying for interest or for the Preferred Dividends. But what about the Cost of Equity? What is the company really paying?

Dividends

It gives up stock appreciation rights

If a firm is losing money, do you still multiply the Cost of Debt by (1 - Tax Rate) in the WACC formula? How can a tax shield exist if they're not even paying taxes?

You still do. It's about the potential of paying debt in the future not about whether the company is paying debt now.

How do you determine a firm's Optimal Capital Structure? What does it mean?

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. Cuz you will always end up with 100% debt.

Let's take a look at companies during the financial crisis (or really, just any type of crisis or economic downturn). Does WACC increase or decrease?

cost of equity:

Risk free rate -

Market Premium +

Beta + (increased volatility)

Cost of debt +

Overall +

How do you calculate the Terminal Value?

1. Multiple method" apply a 5-year exit multiple on their 5 year EBITDA/EBIT/...

2. Gordon Growth Method: final yr FCF * (1 + FCF Growth Rate) / Discount Rate - FCF growth rate

Why would you use the Gordon Growth Method rather than the Multiples Method to calculate the Terminal Value?

In Banking you always use multiples and it's more obtainable. FCF growth Rate is very much a guess games sometimes.

However you will use gordon growth if there's no reasonable comparable/ multiples will changes significantly in the next couple of years.

What's an appropriate growth rate to use when calculating the Terminal Value?

GDP growth rate

How do you select the appropriate exit multiple when calculating Terminal Value?

Normally you look at the Public Comps and pick the median of the set, or something close to it.

What's the flaw with basing the Terminal Multiple on what the Public Comps are trading at?

There is a time lag, the multiples can be different after ten years

Wait a second: why isn't the present value of the Terminal Value, by itself, just the company's Enterprise Value? Don't you get Enterprise Value if you apply a multiple to EBITDA?

That's only the company's far in the future value. DCF shows the ST value of the company.

How do you know if a DCF is too dependent on future assumptions?

if more than 50% of the company's value comes from future value

How can you check whether your assumptions for Terminal Value using the Multiples Method vs. the Gordon Growth Method make sense?

You do both to cross check each other.

You're looking at two companies, both of which produce identical total Free Cash Flows over a 5-year period. Company A generates 90% of its Free Cash Flow in the first year and 10% over the remaining 4 years. Company B generates the same amount of Free Cash Flow in each year. Which one has the higher net present value?

Company A

Should Cost of Equity be higher for a $5 billion or $500 million Market Cap company?

Higher for 500million, because of higher returns.

What about WACC - will it be higher for a $5 billion or $500 million company?

Depends on the capital structure.

What's the relationship between Debt and Cost of Equity?

More debt means a higher cost of equity because debts get to be paid first.

Two companies are exactly the same, but one has Debt and one does not - which one will have the higher WACC?

The one without, because debt is cheaper than equity.

Wait a minute, so are you saying that a company that does not take on Debt is at a disadvantage to one that does? How does that make sense?

No, if you have healthy cash flow and you do not need debt then it's a good thing. But it won't be valued as good in a DCF model.

Let's say that we assume 10% revenue growth and a 10% Discount Rate in a DCF analysis. Which change will have a bigger impact: reducing revenue growth to 9%, or reducing the Discount Rate to 9%?

Discount Rate

What about if we change revenue growth to 1%? Would that have a bigger impact, or would changing the Discount Rate to 9% have a bigger impact?

No Sure, probably revenue

The Free Cash Flows in the projection period of a DCF analysis increase by 10% each year. How much will the company's Enterprise Value increase by?

Not sure, But certainly less than 10%, because it's discounted.

# Let's say that we want to analyze all these factors in a DCF. What are the most common sensitivity analyses to use?

Revenue Growth vs. Terminal Multiple

EBITDA Margin vs. Terminal Multiple

Terminal Multiple vs. Discount Rate

Terminal Growth Rate vs. Discount Rate

A company has a high Debt balance and is paying off a significant portion of its Debt principal each year. How does that impact a DCF?

UFCF: No Change

LFCF: reduce cash flow

So if you're using Levered FCF to value a company, is the company better off paying off Debt quickly or repaying the bare minimum required?

It's always better to pay the bare minimum.

Explain why we use the mid-year convention in a DCF.

Assume cash flow comes evenly throughout the year instead of by the end of the year. so you use 0.5 for the first year, 1.5...

What's the point of a "stub period" in a DCF? Can you give an example?

You use a stub period when you're valuing a company before or after the end of its fiscal year and there are 1 or more quarters in between the current date and the end of the fiscal year.

# What discount period numbers would you use for the mid-year convention if you had a stub period - e.g. Q4 of Year 1 - in a DCF?

Q4 Year 1Year 2Year 3Year 4Year 5 Normal Discount Periods with Stub: 0.25 1.25 2.25 3.25 4.25 5.25 Mid-

Year Discount Periods with Stub: 0.125 0.75 1.75 2.75 3.75 4.75

How does the Terminal Value calculation change when we use the mid-year convention?

Multiples Method: You add 0.5 to the final year discount number to reflect that you're assuming the company gets sold at the end of the year.

Gordon Growth Method: No Change

How does a DCF for a private company differ?

Same. But when it comes to WAAC you would use comparable public comps.

How do you factor in one-time events such as raising Debt, completing acquisitions, and so on in a DCF?

You don't, unless it's recurring

What should you do if you don't believe management's projections in a DCF model?

You do one on your own.

You could "hair-cut" management's projections

Do sensitivity table

Why would you not use a DCF for a bank or other financial institution?

Banks use Debt differently than other companies and do not use it to finance

their operations - they use it to create their "products" - loans - instead.

Also interest is an important part of their business model.

It's more common to use a Dividend Discount Model or Residual Income Model

# Walk me through a Dividend Discount Model (DDM) that you would use in place of a normal DCF for financial institutions.

Project the company's earnings, down to Earnings per Share (EPS).

Assume a Dividend Payout Ratio - what percentage of the EPS gets paid out to shareholders in the form of Dividends - based on what the firm has done historically and how much regulatory capital it needs.

Use this to calculate Dividends over the next 5-10 years.

Do a check to make sure that the firm still meets its required Tier 1 Capital Ratio and other capital ratios - if not, reduce Dividends.

Discount the Dividends in each year to their present value based on Cost of Equity - NOT WACC - and then sum these up.

Calculate Terminal Value based on P / BV and Book Value in the final year, and then discount this to its present value based on the Cost of Equity.

Sum the present value of the Terminal Value and the present values of the Dividends to calculate the company's net present value per share.

# Do you think a DCF would work well for an oil & gas company?

CapEx needs are enormous and will push FCF down to very low levels.

Commodity prices are cyclical and both revenue and FCF are difficult to

project.

How does a DCF change if you're valuing a company in an emerging market?

No good public comps. High WAAC. Add in a premium for political risk and uncertainty

When you're calculating WACC, do you count Convertible Bonds as real Debt?

depends in-the-money or not

What about the treatment of other securities, like Mezzanine and other Debt variations?

If interest is tax-deductible, you count them as Debt in the Levered Beta calculation; otherwise they count as Equity, just like Preferred Stock.

For WACC itself, you normally look at each type of Debt separately and assume that the "Cost" is the weighted average effective interest rate on that Debt.

Should you ever factor in off-Balance Sheet Assets and Liabilities in a DCF?

Yes if they have a huge impact.

# How do Pension Obligations and the Pension Expense factor into a DCF?

If you're running an Unlevered DCF and you're counting Unfunded Pension Obligations as Debt, you should exclude pension-related expenses from Unfunded obligations on the Income Statement and Cash Flow Statement, for the same reason you exclude interest payments on Debt.

For a Levered FCF you would do the opposite and leave in these expenses because they're a form of "interest expense."

Can you explain how to create a multi-stage DCF, and why it might be useful?

Because some industries might be cyclical.

How does Net Income Attributable to Noncontrolling Interests factor into the Free Cash Flow calculation?

No Impact because you subtract it at the bottom of the Income Statement but then add it back on the Cash Flow Statement

What about Net Income from Equity Interests?

No Impact.

# Which tax rate should you use when calculating Free Cash Flow - statutory or effective?

Normally you use the effective tax rate because you want to capture what the company is actually paying out in taxes, not what it "should" be paying out according to standard federal and state rates.

# When calculating FCF, you always take into account taxes. But when you calculate Terminal Value, you don't do that - isn't this inconsistent? How should you treat it?

Here's how to think about this one:

• First off, if you use the Gordon Growth method to calculate Terminal Value, you are taking into account taxes because you're valuing the company's Free Cash Flow into perpetuity.

And if you're using the Terminal Multiple method, you're implicitly taking into account taxes because you're assuming that [Relevant Metric] * [Relevant Multiple] is the company's present value from that point onward, as of the final year. You're not assuming that the company is actually sold... just estimating what a buyer might pay for it, fully taking into account the value that the buyer would receive from its far-in-the- future, after-tax cash flows.

We're creating a DCF for a company that is planning to buy a factory for $100 in Cash in Year 4. Currently the net present value of this company, according to the DCF, is $200. How would we change the DCF to account for the factory purchase, and what would the new Enterprise Value be?

Easy just minus 100 and discount it.

Walk me through what flows into Retained Earnings.

Retained Earnings = Old Retained Earnings Balance + Net Income - Dividends Issued

Walk me through what flows into Additional Paid-In Capital (APIC).

APIC = Old APIC + Stock-Based Compensation + Stock Created by Option Exercises

What are examples of non-recurring charges we need to add back to a company's EBIT / EBITDA when looking at its financial statements?

Restructuring Charges

Goodwill Impairment

Asset Write-Downs

Bad Debt Expenses

Legal Expenses

Disaster Expenses

Change in Accounting Procedures

Why would the Depreciation & Amortization number on the Income Statement be different from what's on the Cash Flow Statement?

This happens if D&A is embedded in other Income Statement line items. When this happens, you need to use the Cash Flow Statement number to arrive at EBITDA because otherwise you're undercounting D&A.