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Welcome to the Knowledge Check. If you have prior knowledge of Corporate Valuation Discounted Cash Flow (DCF) Analysis, try the Knowledge Check. A perfect score is no guarantee that you know everything covered in the tutorial, but a less than perfect score will help you identify any knowledge gaps. If the subject of this tutorial is new to you, the Knowledge Check will indicate the level of the information that youre about to encounter. You may think you dont know much about this area, but you might surprise yourself!
Question 1 of 5
Discounted cash flow analysis is typically based on which of the following types of projected free cash flow? Neutral Absolute Levered Unlevered Correct. You will learn about the fundamentals of DCF analysis in Topic 1, Overview of DCF Analysis.
Question 2 of 5
Which one of the following is NOT a component of the weighted average cost of capital? Tax rate Cost of debt Market value of equity Market value of current assets Correct. You will learn about the components of WACC in Topic 2, Weighted Average Cost of Capital (WACC).
Question 3 of 5
Which of the following statements about terminal value is true? Terminal value estimates when a company will no longer exist. Terminal value provides an estimate of the cost of capital for a firm.
Terminal value provides an estimated valuation of a business at a future period beyond the forecasted free cash flows. All of the above None of the above
Question 4 of 5
Which of the following is the correct formula for calculating enterprise value in a DCF valuation? Enterprise value = PV of free cash flows + PV of terminal value Enterprise value = PV of free cash flows - PV of terminal value Enterprise value = PV of free cash flows x PV of terminal value Enterprise value = PV of free cash flows / PV of terminal value Correct. You will learn how to calculate enterprise value in Topic 4, Deriving a Discounted Cash Flow Valuation.
Question 5 of 5
True or False? Valuation ranges for the same company derived from public comparables, acquisition comparables, and DCF analyses always produce the same result. True False Correct. You will learn about the valuation ranges in Topic 5, Summarizing Valuation Ranges. On completion of this tutorial, you will be able to: describe the theoretical basis of a discounted cash flow (DCF) analysis, including the advantages and other considerations estimate and calculate a discount rate (typically, the weighted average capital of cost) used to present value cash flows calculate the terminal value of a company through two popular methodologies (exit multiple and perpetuity growth) perform a discounted cash flow valuation summarize valuation ranges with comparables analyses and DCF
Prerequisite Knowledge Prior to studying this tutorial, you should have a sound knowledge of financial statements, financial statement analysis, and corporate valuation as described in the following tutorials: The Balance Sheet The Income Statement The Cash Flow Statement Financial Statements Ratio Analysis
Corporate Valuation An Overview Corporate Valuation Public Comparables Analysis Corporate Valuation Acquisition Comparables Analysis
holders. The word free means that these cash flows have already covered capital expenditure, working capital, and the investment needs of the business. Therefore, the cash flows are available to all capital structure holders of a company.
capital structure
Capital structure refers to how a business is financed and typically relates to the choice between debt or equity sources of finance.
Because the DCF utilizes a cash flow that is independent of capital structure, the present value of the unlevered free cash flows and present value of the terminal value yield the enterprise or firm value of a company.
Later in this tutorial, we will cover the derivation of equity value and equity value per share from the enterprise value calculated in a DCF analysis.
DCF Analysis
A DCF analysis is based on the projected unlevered free cash flows. Which of the following is true in relation to this statement? The word projected means that there could be a possible bias in the valuation. The word unlevered implies that these cash flows are dependent on capital structure. The word free means that these cash flows do not take capital expenditures, working capital, and investment needs of the business into account. Correct. A DCF valuation is based on projected or forecasted cash flows. These projections typically come from a number of sources and, depending on the source, there could be a possible bias.
You may also have seen other formulas for WACC. Which is the correct one? There may be modifications on WACC if the company has preferred stock. In this case, you would need to estimate that cost of capital and market value to give it a proper weighted average.
WACC
A common representation of the WACC formula is:
WACC Components
Lets examine each component of WACC: Cost of equity
Cost of debt
Click each component for details. When you have finished, click the Forward arrow to continue.
Cost of Debt
The cost of debt is the cost to the company of raising debt capital. It can be thought of as the risk-free rate of borrowing plus a spread based on the credit rating/credit profile of the company. Ideally, the cost of debt is observable in the market if the companys debt is publicly traded. Since the cost of debt reflects a longer-term cost of borrowing, it is typical to look at the yield to maturity from a long-term bond of at least ten years. This yield is normally quoted as a spread over a risk-free benchmark (such as a government security). If a company does not have publicly traded debt, there are several ways to estimate the cost of debt. Obtain a quote from debt capital markets professionals if you are working in a financial institution. Such a quote, usually a spread over a risk-free benchmark, will be based on risk/credit profile of the company. Examine the companys debt footnote (in 10-K filings or annual reports). The weighted average cost of debt based on coupon rates may yield a rough estimate, but be careful: Have interest rates changed since the issuance? Has the companys credit profile changed? Did the company have a recent debt issuance? What was the interest rate? Ask whether a comparable company has publicly traded debt or a recent debt issuance. As with any relative analysis, be careful of conclusions: How similar are the risk/credit profiles of the companies?
After the cost of debt has been estimated, it should be tax-effected, usually at the marginal tax rate. The cost of debt is examined on an after-tax basis because interest expense is tax deductible (assuming the company generated enough profits to utilize the interest tax shield), so the true cost of borrowing is the after-tax interest expense.
The marginal tax rate refers to the amount of tax paid on an additional dollar of income - tax obligations increase as taxable income rises.
The market value of equity (E) is calculated in a similar manner to a public comparables analysis: share price times the number of diluted shares outstanding. For the market value of debt (D), practitioners typically use the book value of debt as a common, practical proxy for market value. Caution should be exercised, however, as any recent substantial changes in the risk-free rate or changes in a companys credit profile can mean that the market value of debt will differ dramatically from the book value.
What is the cost of equity under CAPM, correct to one decimal place? %
Calculating WACC
The following information is available about a company:
Utilizing the cost of equity given above, calculate the WACC. Remember to use the after-tax cost of debt. Input your answer correct to two decimal places.
This approach would yield the same answer as working down from EBITDA as long as you use the same tax rate.
sustaining capital investment (that is, capital expenditure replaces asset base reductions through depreciation) steady state working capital needs no deferred taxes
What is the present value (as of January 1, 20X1) of the unlevered free cash flows assuming a discount rate of 9.5%?
What is the present value (as of January 1, 20X1) of the unlevered free cash flows, assuming a discount rate of 10.5% this time? Input your answer correct to the nearest whole number. USD million
You can also use the following spreadsheet to perform the calculation: Click the Back arrow to try again.
Terminal Value
Because it is usually impractical to extend the projections beyond a reasonable forecast period, a terminal value is used to capture the value of the company beyond the forecast period. There are two methods commonly used: Exit multiple method
Click each method for details. When you have finished, click the Forward arrow to continue.
Because both the exit multiple and perpetuity growth rate terminal approaches are commonly used, proficiency in each approach is essential when performing discounted cash flow valuations.
Enterprise value - net debt = USD 527.6m - USD 75m = USD 452.6m