DCF Conceptual Questions

Why is WACC used to discount Unlevered Free Cash Flow?

WACC (Weighted Average Cost of Capital) is used to discount Unlevered Free Cash Flow (UFCF) because it matches the risk profile of the cash flows with the overall risk of the entire capital structure. It reflects the blended cost of financing from debt and equity, ensuring an appropriate discount rate for valuing the firm's operations without considering leverage.

Why does increasing WACC decrease Enterprise Value?

Increasing WACC raises the discount rate applied to free cash flows, resulting in lower present values for these cash flows and, consequently, a decrease in Enterprise Value. This is because higher discount rates reflect greater risk, making future cash flows less valuable in today's terms.

Why does increasing terminal growth increase Terminal Value?

Increasing terminal growth raises the expected future cash flows beyond the forecast period, leading to a higher Terminal Value. A higher growth rate reflects the potential for more profitable business operations in perpetuity, thus increasing the value derived from those future cash flows.

Why must terminal growth be less than WACC, under the perpetuity growth method?

Terminal growth must be less than WACC because if it exceeds WACC, it implies that the business is expected to grow faster than its cost of capital indefinitely, which is unsustainable. This condition ensures that future cash flows remain realistic and maintain a present value that can be calculated.

How do reinvestment requirements, growth, and ROIC affect valuation?

Reinvestment requirements impact valuation by determining the amount of cash flows that must be allocated to maintain or grow the business. Higher reinvestment needs can reduce the free cash flows available for distribution to investors, leading to a lower valuation. This is because when more cash is committed to reinvestment, less is available for dividends or other distributions, thereby reducing the overall perceived value of the business.

• If ROIC > WACC = value-creation

• If ROIC < WACC = value-destruction

Growth only creates value when it is funded by high-returning reinvestment.

When do you use the perpetuity growth method vs the exit multiple method when calculating terminal value?

• PGM —> valuing a mature company that is expected to growth at a steady, predictable rate (in line with nominal GDP

  • Tradeoffs: Extremely sensitive to small changes in growth + WACC assumptions

• EMM —> when you have reliable comparable company or precedent transaction data. Good when forecasting perpetual cash flows long-term is too speculative

  • Tradeoffs: anchors terminal value to current market sentiment, thereby introducing relativity into intrinsic valuation model

In practice, bankers almost always calculate Terminal Value using the Exit Multiple Method because market multiples are tangible and easier to defend to a board or a client, but we will always run the Perpetuity Growth Method side-by-side as a sanity check to ensure the implied exit multiple makes logical sense.