Principal repayment in a DCF

Kuan-Li's picture
Rank: Chimp | 14

Hi guys, I'm reading 400 Investment Banking Questions these days. Question 32 in the part of DCF- basic says "A company has a high debt load and is paying a significant portion of principal each year. How do you account for this in a DCF?"
And the answer is :
Trick question. You don't account this at all in a DCF, because paying off debt principal shows up in Cash Flow from Financing on the Cash Flow Statement - but we only go down to Cash Flow from Operations and then subtract Capital Expenditure to get free cash flow.
If we are looking at Levered Free Cash Flow, then our interest expense would decline in future years due to the principal being paid off - but we still wouldn't count the principal repayments themselves anywhere.

I can understand why the repayment has nothing to do with Un-levered Free Cash Flow, but why we don't count the principal when looking at Levered Free Cash Flow?
I think the repayments should be subtracted form FCFF to get FCFE.
thanks a lot.

Comments (10)

Feb 21, 2020

Isn't most of the debt being amortized over its life so the interest expense implicitly contains the principal repayment? If not maybe it's assumed that the firm will be able to refinance existing debt at the same rate in perpetuity?

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Feb 22, 2020

Thanks so much! I understand now.

Feb 23, 2020

Term loans that contain an amortization portion do NOT include the principle repayment in the revenue statement lumped in with interest or finance expense. Amort would show up in the cashflow statement like any cashflows from financing would.

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Most Helpful
Feb 21, 2020

Thing is that you want to keep a constant capital structure over time, otherwise your (levered) cost of equity would be decreasing over time as well while you most likely keep it constant now.

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Feb 22, 2020

Thanks for your answer which is so helpful :)

Feb 21, 2020

Remember you are looking at FCFF to value the firm, ultimately to arrive at Enterprise Value. Discounting FCFE would give you a value for the firm's equity, which will not be the total purchase price for the target.

Progress is impossible without change...

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Feb 21, 2020

Here's my understanding, unlevered cash flow is not taking into the consideration of debt. Therefore, we shouldn't include principle debt payment in our fcf calculation for the DCF, since the DCF is trying to help us arrive at a EV.

If we calculate the principle payment in levered cf, then the initial principle payment will also affect all the levered cf thereafter, for example lower interest. Levered CF should also only account for mandatory debt repayment, anything additional shouldn't be accounted for in our calculation of the levered CF. That's why models are just models and not necessarily reflect exactly what the real situation is. The models should always be altered to reflect what you're trying to figure out.

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Feb 22, 2020

Thanks for your answer.
This points to another question. What is "mandatory debt repayment" ? Why we only account for it ?

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Feb 23, 2020

Mandatory debt repayment is required principle payment as per the credit agreement. Think of a mortgage that you have, that will be your monthly payment excluding the interest portion.

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Feb 24, 2020
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