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This is awesome. One mistake I caught...

You say: How do you get the terminal value and how would you get the main assumptions?
- Either:

(1) Gordon Growth Model:
o (Terminal Year Cash Flow * (1 + Terminal Growth) ) / (Discount Rate – Discount Rate)

It should be (Discount Rate - Terminal Growth)

Incredibly detailed though. Silver Banana from me sir.

“Success means having the courage, the determination, and the will to become the person you believe you were meant to be”
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Asia_i_Banker:

Thanks a lot @nontargetPSD92 - I have fixed that

Threw you a SB. One question I had is, because FCFE is supposed to capture the equity holder's claims on operations, would you include CFF (ie debt repayment/issuance?) from what i remember, M&I said don't include debt issuance/repayment when calculating FCFE.

Thanks for the detailed guide!

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Great write up! Thanks! It will come handy for the interviews.

Great summary... nice refresher as well.

Progress is impossible without change...
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You would include all debt financing cash flows in the DCFE because this DCFE should show all of the cash flows in the company other than those that are theoretically for the equity holders - isolating the view of cash from the equity holders' perspective.

To take a \$100m capex project as an example, if you have raised \$90m in debt, the equity shareholders would theoretically have to pay the \$10m of remaining costs. This \$10m might be a new equity infusion, or it may simply be from the cash balance inside of the company, however it fundamentally reduces cash that the equity holders could theoretically use/enjoy. If you only raised \$20m of debt, then the remaining \$80m of value will have to come from equity holders.

Later on, when the \$20m has to be paid back, that \$20m will be diverted from (deducted from) the earnings that would otherwise go to the equity holders. The debt interest payments would also divert cash from the equity holders and towards other parties (debt holders).

One way to think about it is that a company would never hold cash on its balance sheet. It would dividend out all cash that happens to settle in the balance sheet (no dividend restrictions, or dividend distribution taxes, etc) and if the company was facing a cash shortage after taking into account all cash flows (including debt cash flows), then the equity holders would have to pay in more cash to fund the business. All that the DCFE cares about is this cash going in and out of the equity holders domain (regardless of whether or not the cash is realistically in the personal equity holder's own bank account).

Go East, Young Man
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Maybe I am misunderstanding your comment, however I think what you are thinking about is a graph that plots how the % movement in the index relates to the % movement in the stock price. You could then plot a regression line through those plotted points. However, of course you are not going to get a perfect match, so that R-sq is going to measure how well that regression line matches the plotted points.

A high R-sq is going to indicate that all of those dots are near the line, which would mean that if the market goes up 1%, then the stock is very likely to go up 1%. You would then (in you CAPM formula) take into account a lot of that market risk premium. If the market plays virtually no role in predicting the movement of the stock, then the R-sq (beta) is going to be low and this is going to drive down your cost of equity.

Go East, Young Man
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Beta is the covariance of the asset's return and the benchmark's return divided by the variance of the benchmark. Covariance is a function of volatility and correlation.

Also, if beta = r-squared, then beta is bounded at (0,1) because r (correlation) is bounded at (-1,1).

Hello,

I think this could help :

• FCFF
= EBIT(1-t) + D&A - Capex - ΔNWC
= NI + D&A + Int(1-t) - Capex - ΔNWC
= EBITDA(1-t) + D&A*t - Capex - ΔNWC
= CFO + Int(1-t) - Capex

• FCFE
= NI + D&A - Capex - ΔNWC + Net borrowing
= FCFF - int(1-t) + Net borrowing
= CFO - Capex + Net borrowing

For those in levfin
Levered free cash flow (cash available for debt repayment)
= EBITDA - tax paid - cash interest - ΔNWC - cash financial items - cash exceptionals - capex - acquisitions

@CyrilN this is not the whole picture. You have to, for example, deduct interest income on your cash balance (net of cash) when you are doing a DCFE.

I suggest people just use my original example above.

Go East, Young Man

Of course it is a simplified version but it is enough for most internship interviews and doing this little summary greatly helped me for my interviews in levfin. It would not help for really technical interviews / case studies

Just a quick question:

when you say

+ FCFF
+ Tax on EBIT
- Actual tax paid
- Gain on investments (net of tax)
- Interest on cash (net of tax)
- Interest on debt
+ Drawdown/(Repayment) of debt
= FCFE

What do you mean by gain on investments ? Is that capital gains on sale of fixed assets ? If yes, shouldn't it be already excluded from FCFF as it is non cash?

Thanks !

Funniest

Maybe because it is 4am now in hong kong after quite a bit of wine, but I am having difficulty coming up with a holistic answer to this. I might have to reword that "+gain on investments" into "+ other unique cash/non cash adjustments" as it would depend on the nature of the item and how else it would have been accounted throughout the statements.

Go East, Young Man
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Yeah, I agree with you. If you are just going out for some basic low level interview, you are probably not going to come across such detail as this (unless the interviewer doesn't like you).

Although it is nice to know (especially for the monkeys here who are actually working in this industry) why you would need to deduct out that interest - otherwise you would effectively be lowering your cost of equity, or giving yourself free money. The assumption of this model is that you are taking that money and investing it elsewhere at a certain rate of equity return. That is what the cost of equity is really about - opportunity cost. If you are including interest on cash balance, then you are theoretically going out and investing the cash elsewhere, while also earning interest on the cash while it is still in the company.

Go East, Young Man

kidflash, yeah, I shut down Rickshaw and decided to return back to IB. One year of trying to get a start-up off the ground certainly sobers you up. I will write a reflective posting sometime in the next several months.

Go East, Young Man

Asia_i_Banker:

kidflash, yeah, I shut down Rickshaw and decided to return back to IB. One year of trying to get a start-up off the ground certainly sobers you up. I will write a reflective posting sometime in the next several months.

Hey man, do you mind if I pm you some questionss about the Asian finance scene?

Can you explain why one would use the marginal tax rate over the effective tax rate when calculating WACC? When you use the WACC to discount FCFFs, wouldn't it make sense to use the effective tax rate because it is most representative of what a firm pays out in tax? Whereas using the marginal tax rate may not apply as much because if your marginal tax rate is 35% -- you may pay 35% on some of your earnings, but 25% at the lower brackets, etc.

@neanderthal that is a good question and I don't have a clear answer (if anyone else has a clear answer, please jump in)

Possible reasons why you might use the marginal tax rate:
- You sometimes (often) have no idea what the ongoing future tax payments may be and probably cannot predict the company's tax planning
- In the end, the company is probably going to have to catch up with some of it's tax obligations
- There is also a mathematical/theoretical reason which I have seen before, but I can't remember now (if someone knows this, please respond)

However, this is one of the things i feel least comfortable with. Even according to this Kellogg pdf (www.kellogg.northwestern.edu/faculty/thompsnt/htm/emp/wacc_emp.ppt), "Tc is the firm's marginal tax bracket, but the effective tax rate is often used as estimate"

I think that one problem is that these formulas were developed in another age before the current environment of permanent tax dodging and the realities of a multitude of different tax regimes faced by an international business.

If you are a Hong Kong corporation, but operate anywhere and everywhere, you may be paying the Mainland Chinese tax rate on some of your cash flow (and you may actually hold PRC debt), US tax rate on some of your cash flow (and may have USA debt), German tax rate on some of your cash flow (and may have German debt), while funnelling some of your profits through a cayman entity which may augment your general tax position across different businesses.

If you were going to stick to the old way of academically putting together a DCFF, you might have to break each nation's business segment into an entirely different DCFF. This would be terrible.

So, I think you might have to decide on a case by case basis, looking at each firm's historic tax situation and making a judgement. If this is a Singapore coffee shop chain that only operates in Singapore, I'm probably going to use the Singapore marginal rate. Even if this coffee shop business might have paid a slightly lower rate last year, it's probably not going to be a permanent situation. If this is Starbucks, I might consider using the effective rate.

Go East, Young Man
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Thanks for the input, it makes sense that you would want to use a tax rate that would be easily predicted over time since what they paid historically may not be permanent due to deferred tax implications, etc.

I think it's also very important to remain calm and pace yourself when answering technical questions. Some bankers may press on several components of the DCF, and it is very important to not get agitated or frazzled. Also, if you forget how to do a step or don't know the answer to a question, admit you don't know. Give an attempt to answer it, but state you don't know. Bankers appreciate the honesty more than the bs, and they'll know if you are bsing!

Great post!

Can anyone comment on the comprehensiveness of this post compared to the technical section of an IB Interview guide?

*Note:I'm wondering if I can forego purchasing a guide and use this post among others. I am not implying the authors post didn't meet the breadth of a guide.

"Not me. Im in my prime"

Had a question as well: is the FCFF just unlevered FCF and FCFE=levered FCF?
Also, I can't find too much info on DCFE, is this knowledge going to be asked in BB IB SA interviews, any links to info? I'm studying from the WSO now, appreciate the help!

Posting to save this thread. Sorry for reviving this. Can't find a function to just save the link.

Can someone please shed some light on why cash and cash equivalents are not in any of these enterprise or equity value calculations? I was always taught:
EV = Mkt value equity + Mkt value Debt + Mkt value Pref shares - Cash&Cash Equivalents

First of all thanks to @AsiaiBanker" for this great guide. Could sb please explain further how we should handle interest income and expenses, particularly on the FCFF->FCFE conversion? What I struggle with is:

1) You start with Net Income (which is supposed to include the net impact of interest income/expenses) and then you proceed with "- Interest on cash (net of tax)".

I read the "You have to, for example, deduct interest income on your cash balance (net of cash) when you are doing a DCFE." and "...otherwise you would effectively be lowering your cost of equity, or giving yourself free money."

But I do not get it..

2) In the second formula, starting from FCFF, again a) I do not understand why you subtract interest of cash (net of tax) and additionally, b) why the subtracted interest on debt is not net of tax. I expected sth like: FCFE=FCFF-(i exp (1-tax) + net borrowings; given that interest expenses are tax deductible.

Is it because of the additional separate "-actual tax paid" line? If so, why the words "net of tax" on the interest on cash but not on debt?

Could somebody guide me? Many thanks in advance!

A Dutchman in London

1. This is because net income is a post-tax line item and reflects the tax-deductibility of interest payments. Hence, to remove the cash flow to debt holders, we have to minus interest expense and the corresponding tax-savings on the interest to reflect the cash flow to equity holders.

2. I belive the taxes attributable to debt holders would be taken into consideration by the (+tax on EBIT - actual tax paid), leaving the taxes attributable to equity holders for FCFE calculation. That being said, "FCFE=FCFF- i exp (1-tax) + net borrowings" is logical too.

Asian banks are pretty strict about technical skills in general imo

Thank you for the valuable article. I am a undergrad at one of the top3 uni in Hong Kong, and I am looking forward to meeting other WSO members based in Hong Kong. :)