Why do you add back non-cash charges?
-these include D&A and stock based compensation
-add them back because you want to reflect how the company saves
... [Show More] on taxes but does not actually pay cash for the line items
How does the DCF replicate the CF statement but takes into account what changes?
* CFO - takes everything
*CFF - eliminates everything bc items are either related to debt (not applicable in unlevered FCF or one time equity issuance / share repurchase)
*CFI - only takes capex (usually only recurring item year to year)
Let's say that Accounts Receivable goes up by $10 and Inventory goes up by $10 and on the other side, Deferred Revenue goes up by $10. How does cash change here?
current assets +20 --> FCF down 20
current liabilities -10 --> FCF up 10
= -10 FCF
Now let's say that AR goes down by $10, Inventory goes up by $10, Prepaid Expenses goes down by $10, and on the other side Accounts Payable goes up by $10 and Deferred Revenue goes up by $10
assets: -10 +10 -10 = -10 --> FCF up 10
liabilities: +10 +10 = +20 --> FCF up 20
=+30 FCF
In NWC (operating assets and liabilities) what do you exclude and why?
current assets: exclude cash and marketable securities -----
-exclude cash bc you're calculating change in cash at the bottom of the cash flow statement
-investing activities are normally one time purchases
current liabilities
-exclude debt bc financing activitites
All else equal, do smaller or larger companies have higher WACCs?
-smaller companies
-intuitively it is because they are inherently riskier
-from a calculation standpoint, this is factored in CAPM where smaller companies have higher beta
(same is also true when comparing emerging market companies to developed market ones)
What is the cost of debt in the WACC calculation?
the cost of debt is just the interest rate on the debt
Why is there a "cost of equity"?
1. if the company issues dividends to common shareholders, that is an actual cash expense
2. by issuing equity to other parties, the company is giving up future stock appreciation to someone else rather than keeping it for itself
CAPM
risk free rate + equity risk premium * levered beta
formulas for levering and un-levering beta
-levered beta takes into account capital structure
-unlevered doesn't
unlevered beta = levered beta/ (1+(1-tax rate)x(debt/equity value))
-essentially removing the additional risk from debt with this formula
levered beta = unlevered beta / (1+(1-tax rate)x(debt/equity value))
-let's increase unlevered beta by however much additional risk the debt adds
why do you un-lever and re-lever beta?
to calculate beta you use a set of comparable companies, so for each one:
-have to derive levered beta, then un-lever it so we just get the inherent business risk not any risk associated with debt
-then take the median of the un-levered betas
-then re-lever the beta based on your company's debt structure to account for debt
In the wacc formula.. is debt, preferred stock, or equity the cheapest? next cheapest?
cheapest: DEBT
-debt pushes down WACC because cost of debt is almost always lower than cost of equity because interest rates on debt are lower and interest is tax-deductible
next cheapest: PREFERRED STOCK
-generally cheaper than equity but not as cheap as debt because preferred dividends are not tax-deductible
most expensive: EQUITY
-cost the most because you would expect to earn more investing in the stock market over the long term than investing in bonds
How does debt increase the cost of equity?
debt increases the riskiness of a company, thus it increases LEVERED BETA which increases CAPM
-intuitively debt increases the chances of you defaulting
If you are calculating FCF to equity or levered FCF, would you then use unlevered beta (beta that doesn't take into account capital structure?)
NO! TRICK QUESTION.
YOU ALWAYS WANT TO TAKE INTO ACCOUNT THE ADDITIONAL RISK FROM DEBT EVEN IF YOU ARE CALCULATING EQUITY VALUE BECAUSE IT MAKES BOTH EQUITY AND DEBT RISKIER
What if a company's capital structure changes in the future?
a weakness of WACC is that is assumes a constant capital structure...however, since there is almost no way that a person would know how it will change in the near term, investors don't worry about this
BUT ideally we would use the targeted capital structure
what are two ways to calculate the terminal value?
Gordon Growth Method:
assumes the company grows into the future perpetually
use the formula: Cash flow end year x (1+ growth rate) / ( wacc - growth rate)
PROBLEMS: this means you have to do a MAJOR input which is the growth rate and it's highly sensitive; also make sure this is pretty low and DEFINITELY LESS THAN country's GDP or else the company would be the country's GDP
Multiples Method:
assumes the company gets bought out at a specific multiple
-use comparable companies multiples they're trading at like EV/EBITDA
-you calculated ending year EBITDA, infer the EV (terminal value)
PROBLEMS: obviously this is hard to estimate, doesn't work if the company has no good peers, multiples are based on historicals and aren't a forward looking thing and could change drastically
What input has the biggest effect on company valuation in the DCF generally?
-terminal value (50-70% value)
-discount rate
-a 1% change in discount rate obviously affects the model more than a 1% change in terminal value because the terminal value is a HUGE number
Rules of thumb for cost of equity
-smaller companies have higher cost of equity than larger companies because they're expected to have higher returns
-companies in emerging markets have higher cost of equity
-additional debt raises cost of equity because it makes the company riskier for all investors
-additional equity lowers the cost of equity because the percentage of debt in a company's capital structure decreases
-using historical v calculates beta doesn't have a predictable impact
Rules of thumb for WACC
-WACC is higher for smaller companies and those in emerging markets
-additional debt REDUCES WACC because debt is less expensive than equity [levered beta increases but additional debt more than outweighs it]
-additional preferred stock usually reduces WACC because preferred stock tends to be less expensive than equity
-higher debt interest rates will increase WACC because they increase the cost of debt
What's the point of Free Cash Flow, anyway? What are you trying to do?
the idea is that you're replicating the Cash Flow Statement, but only including recurring, predictable items. And in the case of Unlevered Free Cash Flow, you also exclude the impact of Debt entirely.
That's why everything in Cash Flow from Investing except for CapEx is excluded, and why the entire Cash Flow from Financing section is excluded (the only exception being Mandatory Debt Repayments for Levered FCF).
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
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.
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.
What's an alternate method for calculating Unlevered Free Cash Flow(Free Cash Flow to Firm)?
(1)
EBIT x (1- tax rate) + D&A -capex -changes NWC
(2)
net income + interest expense (1-tax rate) + D&A -capex -changes NWC
(3) CFO + interest x (1-tax rate) -capex
What's an alternate method for calculating levered Free Cash Flow(Free Cash Flow to Equity)?
(1)
net income + D&A -capex -changes NWC + net borrowing
(2)
CFO -capex +net borrowing [Show Less]