Discounted Cash Flow Analysis Practice Questions and Answers
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Discounted Cash Flow
Institution
Discounted Cash Flow
The premise that the value of a company, division, business or collection of assets can be derived from the present value of its projected free cash flow. What is a discounted cash flow analysis premised on?
1. Study the target and determine key performance drivers 2. Project free cash flow 3. Cal...
Discounted Cash Flow Analysis Practice
Questions and Answers
The premise that the value of a company, division, business or collection of assets can
be derived from the present value of its projected free cash flow. ✅What is a
discounted cash flow analysis premised on?
1. Study the target and determine key performance drivers 2. Project free cash flow 3.
Calculate weighted average cost of capital 4. Determine terminal value 5. Calculate
present value and determine valuation ✅What are the five steps in running a
discounted cash flow analysis?
Study the target and determine key performance drivers ✅A thorough understanding
of the target's business model, financial profile, sector, value proposition for customers,
end markets, competitors, and key risks is essential for developing a framework for
valuation
Internal drivers of a company's performance ✅opening new facilities/stores,
developing new products, securing new customer contracts, and improving operational
and/or working capital efficiency
External drivers of a company's performance ✅acquisitions, end market trends,
consumer buying patterns, macroeconomic factors, or even legislative/regulatory
changes
Free cash flow ✅the cash generated by a company after paying all cash operating
expenses and associated taxes, as well as the funding of capital expenditures and
working capital, but prior to the payment of any interest expense
Free cash flow ✅Independent of capital structure as it represents the cash available to
both debt and equity holders
Projection period length ✅This is generally five years but depends on the target's
sector, stage of development, and the predictability of its financial performance
Weighted average cost of capital (WACC) ✅Generally used as the discount rate to
calculate the present value of a company's projected free cash flow
Weighted average cost of capital (WACC) ✅It represents the required return on the
invested capital in a given company
, Weighted average cost of capital (WACC) ✅Dependent on a company's "target"
capital structure as debt and equity components have different risk profiles and tax
ramifications
Weighted average cost of capital (WACC) ✅It can be thought of as an opportunity cost
of capital or what an investor would expect to earn in an alternative investment with a
similar risk profile
Determine the target capital structure that is consistent with long-term strategy ✅This
is represented by the debt-to-total capitalization and equity-to-total capitalization ratios
It's assumed that their management teams are seeking to maximize shareholder value
✅Why do public comparable companies provide a meaningful benchmark for
determining the target capital structure?
WACC gradually decreases due to the tax deductibility of interest expense ✅What
happens as the proportion of debt in the capital structure increases?
The cost of potential financial distress begins to override the tax advantages of debt
✅What happens once the threshold of the target's optimal capital structure is crossed?
The increased probability of insolvency (and bankruptcy) ✅What do the negative
effects of an over-leveraged capital structure include?
Its credit profile at the target capital structure ✅What does a company's cost of debt
reflect?
On the basis of the current yield to maturity for all outstanding debt ✅How is the cost
of debt for publicly traded bonds determined?
CAPM ✅What is based on the premise that equity investors need to be compensated
for their assumption of systematic risk in the form of a risk premium, or the amount of
market return in excess of a stated risk-free rate?
Systematic risk ✅the risk related to the overall market, which is also known as the non-
diversifiable risk
A company's level of systematic risk ✅What depends on the covariance of its share
price with movements in the overall market (as measured by its Beta (β))?
Unsystematic risk ✅This is company- or sector-specific and can be avoided through
diversification.
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