Interview DCF example
Hello All,
Would anyone be able to provide an interview dcf question? I would like to get an understanding of what might come up in an interview.
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Walk me through a DCF.
-Walk me through a DCF? -What levers have the greatest impact on a DCF valuation? -What do you use as the discount rate in a DCF? -If tax rates increase, how does the DCF valuation change? -How do you calculate terminal value (TV) in a DCF? -What portion of the valuation should the TV make up? -When would you use Exit Multiples vs Gordon Growth in a DCF? -What would you base your exit multiples on? -Calculate Unlevered Free Cash Flow? -If you want to calculate equity value in your DCF, what will you use as the discount rate? -How does an increase in Accounts Receivable affect your DCF valuation? -How does the DCF change for a company with 0 cash flow?
would you be able to offer any solutions?
my guy these are all basic, basic dcf questions. studying the technical guide’s dcf portion would answer these and then some, and you could probably have a great understanding of a dcf in a couple of hours
these are all in the BIWS guides
How many MBA associates does it take to do a single DCF?
Answer: 5 MBA associates to delegate, 1 first year analyst to perform the work
what are three ways that the tax rate can affect a DCF valuation?
I can’t think of two WACC and the the calculation of free cash flows, what would the third be ?
you got the two - the third that I can see is in the levered beta formula in the cost of equity. cost of equity depends on leverage which also accounts for the tax shield on debt (just look up the formula for levered beta and you’ll see)
A trickier DCF question:
How would you use DCF for a company with changing leverage?
leverage does not affect unlevered FCFs, only has an impact on the WACC. Because the capital structure changes during the projection period, need to reflect the risks of leverage on those cash flows in the discount rate. So the WACC would be different for each year with changing leverage?
but generally, this is an unforeseeable assumption, so the capital structure is remained to be constant throughout the time horizon.
if leverage is changing over time, then you probably aren’t concerned with an unlevered DCF as a levered DCF (or an LBO). unlevered DCF goal is to calculate the total enterprise value available to all capital holders regardless of the capital structure (although that can be seen in the WACC)
You couldn’t use a traditional WACC method, because it would be changing every year. instead, you would use an APV calculation (Adjusted Present Value), which values the debt tax shield each year
depends... I would say you can go w a levered model and include principal/interest payments each year. Otherwise, you still go unlevered and try and make different assumptions on the Debt for moving from EV to Equity Value in the Bull/Bear cases.
Yes, absolutely. If leverage changes every year, WACC needs to be re-calculated every year with correct leverage.
For terminal value, it is fine to assume the target capital structure (i.e. constant leverage going forward).
from this standpoint then, the steady state capital structure would be just as important as steady state growth and margins (as in the terminal growth rate and margins reflect in perpetuity). interesting to look at this way. so would you need to keep projecting until capital structure is also at a steady state so that the WACC used to discount the terminal value is a proper measurement? all just in theory tho, in practice I can see this being a little too particular.
I agree with TREBITDA you can use APV for any situation with changing leverage, as it is much easier.
If you have to use standard DCF instead with changing leverage:
Let's assume you have projections for 7 years Y1-Y7 Calculate your cashflows for Y1-Y7 Calculate your discount factors for Y1-Y7 For each discount factor, you calculate its own WACC that will change with leverage. Seven WACCs to calculate! Assume you reach steady state from Y8 onwards and have a constant capital structure from then on. Calculate terminal value by using yet another WACC that applies from then on in order to discount your TV.
I agree, it is a very particular question. I thought we were talking about tricky DCF interview questions though, right? This is frequently an overlooked corner in finance, but it is important to know that WACC indeed is going to change every time with changing leverage.
I would say that it’s more traditional, instead of re-calculating WACC, to use an APV method
I agree. Having said that, I personally never came across APV at work. Only in business school finance classes. However, I did see DCF with changing WACC on a couple of occasions, especially when you are trying to value an illiquid cash flow producing asset with small or no terminal value (shipping deals, satellite deals, etc.)
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Why would anybody working in PE want to ask you a DCF question? I have never seen it used in a deal context.
You are right, DCF does not come up often in a traditional PE deal context.
However, it does come up, especially outside of LBOs. I had to use DCF in the following situations:
1) for deals with infrastructure-like features; 2) for valuing cash flow producing assets with limited terminal value (shipping); 3) for valuing complex illiquid assets, where you would use 7 valuation approaches to establish value - and one of the valuation methods would be DCF. You wouldn't rely on it, but it is a data point; 4) for quarterly portfolio valuations, you are typically asked to use several valuation methods. It was very helpful for one of them to be DCF during the global financial crisis, when the whole world was trading at 3x forward PE.
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