Help me solve the DCF question that destroyed my chances
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If I'm not misunderstanding the question, you're buying a company at (presumably) the value of 5 years of cash flows, discounted. That's approximately an EV/FCF multiple of 5.0x which is quite good for a PE firm.
When you're paying 40 dollars of equity and 60 dollars of debt (which I think is a reasonable spread) and your exit multiple is 5.0x, your IRR will probably in the range of 20-30%, depending on your interest rate, revenue growth, tax rate, and some other factors (cap ex, operating working capital changes, ebitda margin changes, etc.).
For a strategic buyer purchasing at fair value is obviously a steal as well for different reasons, mostly the ones you listed.
I don't understand the question exactly but will give a try.
Basically the reason you buy something in fair value because you can profit by using leverage (vs buy something undervalued and profit by selling it at a higher price). In this case, if you buy this $100 company using 30% equity and 70% debt, and use future cash flow to pay down the debt (let's say pay off 30% debt in 5 years), you get 100% return on equity when you sell the company at same price ($100). This is how LBO works.
Damn. I guess maybe the correct answer was using leverage?
Damn I didn't consider the different sources of financing. I was here thinking it was a cash acquisition.
The correct answer:
The rate at which you discount reflects the risk (or for LBO, usually reflects a hurdle rate). So with a 100 NPV, the investment would yield a return that is above the required return (cost of capital and/or hurdle rate). So even if the buyer and the seller agrees on the same price, the buyer is making a good return on the investment and thus making a good decision.
The reason why your interviewer had asked if you ever worked on an LBO is because on an LBO analysis, you usually compare the rerun to the hurdle rate. So say if the hurdle rate (or a required return) is 15% but the IRR analysis gives 17%, then you would invest. If you have an IRR above the required return, your NPV would be positive.
So tl;dr
Not about leverage or synergies. Just a pure definition of NPV. Positive npv = return above the required return.
Sorry! My bad - I used the word NPV mistakenly; the interviewer never used the term NPV. It is just PV, the DCF of all cash flows and the valuation of the company. Does not include the capital outlay.
If the DCF of the company says it is worth $100 in present day dollars, why would you buy the company for $100?
Two ways to add value in a DCF,
1) increase FCF (numerator; all the operating stuff plus tax and growth you mentioned in original post) and 2) lower discount rate (denominator; capital structure, operational change to lower risk etc).
Since you already covered choice 1), I guess the interviewer was looking for choice 2). Basically the buyer and the seller probably used the same discount rate (presumably WACC), but the buyer has a lower cost of capital (I.e. Conglomerate) or is a financial sponsor (pe firm) with a new capital structure (I.e. Add debt), that ultimately results in lower blended cost of capital.
Tl;dr: yeah, presumably, the buyer is equity sponsor so leverage would yield a good return.
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