1
DISCOUNTED CASH FLOW MODEL EXAM WALL
STREET PREPATION FINAL EXAM ACTUAL
QUESTIONS AND CORRECT ANSWERS ALREADY
GRADED A+ GUARANTEED PASS
How do you calculate the Terminal Value?
You can either apply an exit multiple to the company's Year 5 EBITDA, EBIT or Free Cash
Flow (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
Free Cash Flow * (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 Free Cash Flows from the final year into infinity, as of the final year.
Why would you use the Gordon Growth Method rather than the Multiples Method to calculate
the Terminal Value?
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 rates rather than exit multiples.
Why do you use 5 or 10 years for the "near future" DCF projections?
That's about as far as you can reasonably predict for most companies. Less than 5 years would be
too short to be useful, and more than 10 years is too difficult to project for most companies.
Is there a valid reason why we might sometimes project 10 years or more anyway?
, 2
You might sometimes do this if it's a cyclical industry, such as chemicals, because it may be
important to show the entire cycle from low to high.
What do you usually use for the Discount Rate?
In a Unlevered DCF analysis, you use WACC (Weighted Average Cost of Capital), which
reflects the "Cost" of Equity, Debt, and Preferred Stock. In a Levered DCF analysis, you use
Cost of Equity instead.
If I'm working with a public company in a DCF, how do I move from Enterprise Value to its
Implied per Share Value?
Once you get to Enterprise Value, ADD Cash and then SUBTRACT Debt, Preferred Stock, and
Noncontrolling Interests (and any other debt-like items) to get to Equity Value.
Then you divide by the company's share count (factoring in all dilutive securities) to determine
the implied per-share price.
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?
By itself, this does not mean much - you have to look at a range of outputs from a DCF rather
than just a single number. So you would see what the Implied per Share Value is under different
assumptions for the Discount Rate, revenue growth, margins, and so on.
If you consistently find that it's greater than the company's current share price, then the analysis
might tell you that the company is undervalued; it might be overvalued if it's consistently less
than the current share price across all ranges.
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?)
The setup is similar: you still project revenue and expenses over a 5-10 year period, and you still
calculate Terminal Value.
The difference is that you do not calculate Free Cash Flow - instead, you stop at 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.
Then, you add those up and add them to the present value of the Terminal Value, which you
might base on a P / E multiple instead.
, 3
Finally, a Dividend Discount Model gets you the company's Equity Value rather than its
Enterprise Value since you're using metrics that include interest income and expense.
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?
Most of the time, yes, because all items other than CapEx are generally non- recurring, or at least
do not recur in a predictable way.
If you have advance knowledge that a company is going to sell or buy a certain amount of
securities, issue a certain amount of stock, or repurchase a certain number of shares every year,
then sure, you can factor those in. But it's extremely rare to do that.
Why do you add back non-cash charges when calculating Free Cash Flow?
For the same reason you add them back on the Cash Flow Statement: you want to reflect the fact
that they save the company on taxes, but that the company does not actually pay the expense in
cash.
What's an alternate method for calculating Unlevered Free Cash Flow (Free Cash Flow to Firm)?
There are many "alternate methods" - here are a few common ones:
• EBIT * (1 - Tax Rate) + Non-Cash Charges - Changes in Operating Assets and Liabilities -
CapEx
• Cash Flow from Operations + Tax-Adjusted Net Interest Expense - CapEx
• Net Income + Tax-Adjusted Net Interest Expense + Non-Cash Charges -
Changes in Operating Assets and Liabilities - CapEx
The difference with these is that the tax numbers will be slightly different as a result of when you
exclude the interest.
What about alternate ways to calculate Levered Free Cash Flow?
• Net Income + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx -
Mandatory Debt Repayments
DISCOUNTED CASH FLOW MODEL EXAM WALL
STREET PREPATION FINAL EXAM ACTUAL
QUESTIONS AND CORRECT ANSWERS ALREADY
GRADED A+ GUARANTEED PASS
How do you calculate the Terminal Value?
You can either apply an exit multiple to the company's Year 5 EBITDA, EBIT or Free Cash
Flow (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
Free Cash Flow * (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 Free Cash Flows from the final year into infinity, as of the final year.
Why would you use the Gordon Growth Method rather than the Multiples Method to calculate
the Terminal Value?
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 rates rather than exit multiples.
Why do you use 5 or 10 years for the "near future" DCF projections?
That's about as far as you can reasonably predict for most companies. Less than 5 years would be
too short to be useful, and more than 10 years is too difficult to project for most companies.
Is there a valid reason why we might sometimes project 10 years or more anyway?
, 2
You might sometimes do this if it's a cyclical industry, such as chemicals, because it may be
important to show the entire cycle from low to high.
What do you usually use for the Discount Rate?
In a Unlevered DCF analysis, you use WACC (Weighted Average Cost of Capital), which
reflects the "Cost" of Equity, Debt, and Preferred Stock. In a Levered DCF analysis, you use
Cost of Equity instead.
If I'm working with a public company in a DCF, how do I move from Enterprise Value to its
Implied per Share Value?
Once you get to Enterprise Value, ADD Cash and then SUBTRACT Debt, Preferred Stock, and
Noncontrolling Interests (and any other debt-like items) to get to Equity Value.
Then you divide by the company's share count (factoring in all dilutive securities) to determine
the implied per-share price.
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?
By itself, this does not mean much - you have to look at a range of outputs from a DCF rather
than just a single number. So you would see what the Implied per Share Value is under different
assumptions for the Discount Rate, revenue growth, margins, and so on.
If you consistently find that it's greater than the company's current share price, then the analysis
might tell you that the company is undervalued; it might be overvalued if it's consistently less
than the current share price across all ranges.
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?)
The setup is similar: you still project revenue and expenses over a 5-10 year period, and you still
calculate Terminal Value.
The difference is that you do not calculate Free Cash Flow - instead, you stop at 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.
Then, you add those up and add them to the present value of the Terminal Value, which you
might base on a P / E multiple instead.
, 3
Finally, a Dividend Discount Model gets you the company's Equity Value rather than its
Enterprise Value since you're using metrics that include interest income and expense.
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?
Most of the time, yes, because all items other than CapEx are generally non- recurring, or at least
do not recur in a predictable way.
If you have advance knowledge that a company is going to sell or buy a certain amount of
securities, issue a certain amount of stock, or repurchase a certain number of shares every year,
then sure, you can factor those in. But it's extremely rare to do that.
Why do you add back non-cash charges when calculating Free Cash Flow?
For the same reason you add them back on the Cash Flow Statement: you want to reflect the fact
that they save the company on taxes, but that the company does not actually pay the expense in
cash.
What's an alternate method for calculating Unlevered Free Cash Flow (Free Cash Flow to Firm)?
There are many "alternate methods" - here are a few common ones:
• EBIT * (1 - Tax Rate) + Non-Cash Charges - Changes in Operating Assets and Liabilities -
CapEx
• Cash Flow from Operations + Tax-Adjusted Net Interest Expense - CapEx
• Net Income + Tax-Adjusted Net Interest Expense + Non-Cash Charges -
Changes in Operating Assets and Liabilities - CapEx
The difference with these is that the tax numbers will be slightly different as a result of when you
exclude the interest.
What about alternate ways to calculate Levered Free Cash Flow?
• Net Income + Non-Cash Charges - Changes in Operating Assets and Liabilities - CapEx -
Mandatory Debt Repayments
