DCF questions
I didn't understand the answers to some of the questions in the BIWS guide. The questions are as follows:
1. Would increasing the revenue growth from 9% to 10% or increasing the discount rate from 9% to 10% make a bigger impact on the DCF? - answer says that it is the discount rate because the revenue increase doesn't change UFCF by much but this doesn't make sense to me. How do you tell by what % UFCF changes when revenue changes?
2. How does the tax rate affect the cost of equity, the cost of debt, WACC and the implied value in a DCF?- Here, I get how an increase in tax rate reduces the cost of equity, the cost of debt and the WACC. What I don't understand is why this is outweighed completely by the reduction in the UFCF due to tax.
1. A 1% increase in revenue translates to a 1% * (1 - tax rate) increase in UFCF assuming no COGS increase with revenue increase. Think about how that revenue flows through the IS - it increases your EBIT by 1%, and thus your UFCF by 1% * (1 - tax rate). A 1% change in the discount rate will have a much more sizable impact on your valuation
2. Take this proposition to the extreme, suppose t = 100%. Suppose following WACC assumptions: Re = 10%, Rd = 5%, t = 40%, D/V = 0.4 -> WACC = 7.2%, with t = 100%, WACC = 6%. It's all well and good your discount rate went down 1.2% but now you have no UFCF to discount.
For 2, I understand that in that extreme case, this is true but I can't visualize how it would work for other tax rates. It's not immediately clear to me why the fall in UFCF would overshadow the fall in discount rate.
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