Interview DCF example

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.

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.