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Wallstreet Prep Valuation Questions and Answers, Exams of Nursing

Harvard UniversityNursing

Wallstreet Prep Valuation Questions and Answers

Typology: Exams

2024/2025

Available from 07/05/2025

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Wallstreet Prep Valuation Questions and Answers 2024
1. Could you explain the concept of present value and how it relates to compa-
ny valuations?: The present value concept is based on the premise that "a dollar in
the present is worth more than a dollar in the future" due to the time value of money.
The reason being money currently in possession has the potential to earn interest
by being invested today.
For intrinsic valuation methods, the value of a company will be equal to the sum
of thepresent value of all the future cash flows it generates. Therefore, a company
with a high valuation would imply it receives high returns on its invested capital by
investing in positive net present value ("NPV") projects consistently while having low
risk associated with its cash flows.
2. What is equity value and how is it calculated?: Often used interchangeably
with the term market capitalization ("market cap"), equity value represents a com-
pany's value to its equity shareholders. A company's equity value is calculated by
multiplying its latest closing share price by its total diluted shares outstanding, as
shown below:
Equity Value = Latest Closing Share Price × Total Diluted Shares Outstanding
3. How do you calculate the fully diluted number of shares outstanding?: The
treasury stock method ("TSM") is used to calculate the fully diluted number of shares
outstanding based on the options, warrants, and other dilutive securities that are
currently "in-the-money" (i.e., profitable to exercise).
The TSM involves summing up the number of in-the-money ("ITM") options and
warrants and then adding that figure to the number of basic shares outstanding.
In the proceeding step, the TSM assumes the proceeds from exercising those
dilutive options will go towards repurchasing stock at the current share price to
reduce the net dilutive impact.
4. What is enterprise value and how do you calculate it?: Conceptually, en-
terprise value ("EV") represents the value of the operations of a company to all
stakeholders including common shareholders, preferred shareholders, and debt
lenders.
Thus, enterprise value is considered capital structure neutral, unlike equity value,
which is affected by financing decisions.
Enterprise value is calculated by taking the company's equity value and adding net
debt, preferred stock, and minority interest.
Enterprise Value = Equity Value + Net Debt + Preferred Stock + Minority Interest
5. How do you calculate equity value from enterprise value?: To get to equity
value from enterprise value, you would first subtract net debt, where net debt equals
the company's gross debt and debt-like claims (e.g., preferred stock), net of cash,
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Download Wallstreet Prep Valuation Questions and Answers and more Exams Nursing in PDF only on Docsity!

  1. Could you explain the concept of present value and how it relates to compa- ny valuations?: The present value concept is based on the premise that "a dollar in the present is worth more than a dollar in the future" due to the time value of money. The reason being money currently in possession has the potential to earn interest by being invested today. For intrinsic valuation methods, the value of a company will be equal to the sum of thepresent value of all the future cash flows it generates. Therefore, a company with a high valuation would imply it receives high returns on its invested capital by investing in positive net present value ("NPV") projects consistently while having low risk associated with its cash flows.
  2. What is equity value and how is it calculated?: Often used interchangeably with the term market capitalization ("market cap"), equity value represents a com- pany's value to its equity shareholders. A company's equity value is calculated by multiplying its latest closing share price by its total diluted shares outstanding, as shown below: Equity Value = Latest Closing Share Price × Total Diluted Shares Outstanding
  3. How do you calculate the fully diluted number of shares outstanding?: The treasury stock method ("TSM") is used to calculate the fully diluted number of shares outstanding based on the options, warrants, and other dilutive securities that are currently "in-the-money" (i.e., profitable to exercise). The TSM involves summing up the number of in-the-money ("ITM") options and warrants and then adding that figure to the number of basic shares outstanding. In the proceeding step, the TSM assumes the proceeds from exercising those dilutive options will go towards repurchasing stock at the current share price to reduce the net dilutive impact.
  4. What is enterprise value and how do you calculate it?: Conceptually, en- terprise value ("EV") represents the value of the operations of a company to all stakeholders including common shareholders, preferred shareholders, and debt lenders. Thus, enterprise value is considered capital structure neutral, unlike equity value, which is affected by financing decisions. Enterprise value is calculated by taking the company's equity value and adding net debt, preferred stock, and minority interest. Enterprise Value = Equity Value + Net Debt + Preferred Stock + Minority Interest
  5. How do you calculate equity value from enterprise value?: To get to equity value from enterprise value, you would first subtract net debt, where net debt equals the company's gross debt and debt-like claims (e.g., preferred stock), net of cash,

and non-operating assets. Equity Value = Enterprise Value - Net Debt - Preferred Stock - Minority Interest

  1. Which line items are included in the calculation of net debt?: The calculation of net debt accounts for all interest-bearing debt, such as short-term and long- term loans and bonds, as well as non-equity financial claims such as preferred stock and non- controlling interests. From this gross debt amount, cash and other non-operating assets such as short-term investments and equity investments are subtracted to arrive at net debt. Net Debt = Total Debt - Cash & Equivalents
  2. When calculating enterprise value, why do we add net debt?: The underlying idea of net debt is that the cash on a company's balance sheet could pay down the outstanding debt if needed. For this reason, cash and cash equivalents are netted against the company's debt, and many leverage ratios use net debt rather than the gross amount.
  3. What is the difference between enterprise value and equity value?: Enter- prise value represents all stakeholders in a business, including equity shareholders, debt lenders, and preferred stock owners. Therefore, it's independent of the capital structure. In addition, enterprise value is closer to the actual value of the business since it accounts for all ownership stakes (as opposed to just equity owners). To tie this to a recent example, many investors were astonished that Zoom, a video conferencing platform, had a higher market capitalization than seven of the largest airlines combined at one point. The points being neglected were:
  4. The equity values of the airline companies were temporarily deflated given the travel restrictions, and the government bailout had not yet been announced.
  5. The airlines are significantly more mature and have far more debt on their balance sheet (i.e., more non- equity stakeholders).
  6. Could a company have a negative net debt balance and have an enterprise value lower than its equity value?: Yes, negative net debt just means that a company has more cash than debt. For example, both Apple and Microsoft have massive negative net debt balances because they hoard cash. In these cases, companies will have enterprise values lower than their equity value. If it seems counter-intuitive that enterprise value can be lower than equity value, remember that enterprise value represents the value of a company's operations, which excludes any non-operating assets. When you think about it this way, it

looking at the multiples of comparable companies recently acquired, which is called "transaction comps."

  1. What are the most common valuation methods used in finance?: Compa- rable Company Analysis ("Trading Comps") Comparable Transactions Analysis ("Transaction Comps") Discounted Cash Flow Analysis ("DCF") Leveraged Buyout Analysis ("LBO") Liquidation Analysis
  2. What is Comparable Company Analysis ("Trading Comps")?: Trading comps value a company based on how similar publicly-traded companies are currently being valued at by the market.
  3. What is Comparable Transactions Analysis ("Transaction Comps")?: - Transaction comps value a company based on the amount buyers paid to acquire similar companies in recent years.
  4. What is Discounted Cash Flow Analysis ("DCF")?: DCFs value a company based on the premise that its value is a function of its projected cash flows, discounted at an appropriate rate that reflects the risk of those cash flows.
  5. What is Leveraged Buyout Analysis ("LBO")?: An LBO will look at a potential acquisition target under a highly leveraged scenario to determine the maximum purchase price the firm would be willing to pay.
  6. What is Liquidation Analysis?: Liquidation analysis is used for companies under (or near) distress and values the assets of the company under a hypothetical, worst-case scenario liquidation.
  7. Among the DCF, comparable companies analysis, and transaction comps, which approach yields the highest valuation?: Transaction comps analysis often yields the highest valuation because it looks at valuations for companies that have been acquired, which factor in control premiums. Control premiums can often be quite significant and as high as 25% to 50% above market prices. Thus, the multiples derived from this analysis and the resulting valuation are usually higher than a straight trading comps valuation or a standalone DCF valuation.
  8. Which of the valuation methodologies is the most variable in terms of output?: Because of its reliance on forward-looking projections and discretionary assumptions, the DCF is the most variable out of the different valuation method- ologies. Relative valuation methodologies such as trading and transaction comps are based on the actual prices paid for similar companies. While there'll be some discretion involved, the valuations derived from comps deviate to a lesser extent than DCF models.
  9. Contrast the discounted cash flow (DCF) approach to the trading comps approach.: Discounted Cash Flow (DCF)

Advantages

  • The DCF values a company based on the company's forecasted cash flows.
  • This approach is viewed as the most direct and academically rigorous way to measure value.
  • Considered to be independent of the market and instead based on the fundamen- tals of the company. Disadvantages
  • The DCF suffers from several drawbacks; most notably, it's very sensitive to assumptions.
  • Forecasting the financial performance of a company is challenging, especially if the forecast period is extended.
  • Many criticize the use of beta in the calculation of WACC, as well as how the terminal value comprises around three- quarters of the implied valuation. Trading Comps Advantages
  • Trading comps value a company by looking at how the market values similar businesses.
  • Thus, comps relies much more heavily on market pricing to determine the value of a company (i.e., the most recent, actual prices paid in the public markets).
  • In reality, there are very few truly comparable companies, so in effect, it's always an "apples and oranges" comparison. Disadvantages
  • While the value derived from a comps analysis is viewed by many as a more realistic assessment of how a company could expect to be priced, it's vulnerable to how the market is not always right.
  • Therefore, a comps analysis is simply pricing, as opposed to a valuation based on the company's fundamentals.
  • Comps make just as many assumptions as a DCF, but they are made implicitly (as opposed to being explicitly chosen assumptions like in a DCF).
  1. How can you determine which valuation method to use?: Each valuation method has its shortcomings; therefore, a combination of different valuation tech- niques should be used to arrive at a range of valuation estimates. Using various methods allows you to arrive at a more defensible approximation and sanity-check your assumptions. The DCF and trading comps are often used in concert such that the comps provide a market-based sanity-check to intrinsic DCF valuation (and vice versa). For example,
  1. Explain the importance of excluding non-operating income/(expenses) for valuations.: For both DCF analysis or comps analysis, the intent is to value the operations of the business, which requires you to set apart the core operations to normalize the figures.
  • When performing a DCF analysis, the cash flows projected should be strictly from the business's recurring operations, which would come from the sale of goods and services provided. A few examples of non- operating income to exclude would be income from investments, dividends, or an asset sale. Each example represents income that's non-recurring and from a discretionary decision unrelated to the core operations.
  • When performing comps, the core operations of the target and its comparables are benchmarked. To make the comparison as close to "apples to apples" as possible, non-core operating income/(expenses) and any non-recurring items should be ex- cluded.
  1. Define free cash flow yield and compare it to dividend yield and P/E ratios.: The free cash flow yield ("FCFY") is calculated as the FCF per share divided by the current share price. For this calculation, FCF will be defined as cash from operations less capex. Free Cash Flow Yield (FCFY) = Free Cash Flow Per Share / Current Share Price Similar to the dividend yield, FCF yield can gauge equity returns relative to a company's share price. Unlike dividend yield, however, FCF yield is based on cash generated instead of cash actually distributed. FCF yield is more useful as a fundamental value measure because many companies don't issue dividends (or an arbitrary fraction of their FCFs). If you invert the FCF yield, you'll get share price/FCF per share, which produces a cash flow version of the P/E ratio. This has the advantage of benchmarking prices against actual cash flows as opposed to accrual profits. However, it has the disadvantage that cash flows can be volatile, and period-specific swings in working capital and deferred revenue can have a material impact on the multiple.
  2. Could you define what the capital structure of a company represents?: The capital structure is how a company funds its ongoing operations and growth plans. Most companies' capital structure consists of a mixture of debt and equity, as each source of capital comes with its advantages and disadvantages. As companies mature and build a track record of profitability, they can usually get debt financing

easier and at more favorable rates since their default risk has decreased. Thus, it's ordinary to see leverage ratios increase in proportion with the company's maturity.

  1. Why would a company issue equity vs. debt (and vice versa)?: Equity Advantages
  • No required payments, unlike debt, giving management more flexibility around repayment.
  • Dividends to equity shareholders can be issued, but the timing and magnitude are at the board and management's discretion.
  • Another advantage of equity is that it gives companies access to a vast investor base and network. Disadvantages
  • Issuing equity dilutes ownership, and equity is a high cost of capital.
  • Public equity comes with more regulatory requirements, scrutiny from shareholders and equity analysts, and full disclosures of their financial statements.
  • The management team could lose control over their company and be voted out by shareholders if the company underperforms. Debt Advantages
  • The interest expense on debt is tax- deductible, unlike dividends to equity share- holders (although recent tax reform rules limit the deduction for highly levered companies).
  • Debt results in no ownership dilution for equity shareholders and has a lower cost of capital.
  • Increased leverage forces discipline on management, resulting in risk-averse decision-making as a side benefit. Disadvantages
  • Required interest and principal payments that introduce the risk of default.
  • Loss of flexibility from restrictive debt covenants prevents management from undertaking a variety of activities such as raising more debt, issuing a dividend, or making an acquisition.
  • Less room for errors in decision-making, therefore poor decisions by management come with more severe consequences.
  1. What are share buybacks and under which circumstances would they be most appropriate?: A stock repurchase (or buyback program) is when a company
  • Many companies increasingly pay employees using stock-based compensation to conserve cash, thus share buybacks can help counteract the dilutive impact of those shares.
  • Share buybacks imply a company's management believes their shares are current- ly undervalued, making the repurchase a potential positive signal to the market.
  • Share repurchases can be one-time events unless stated otherwise, whereas div- idends are typically meant to be long-term payouts indicating a transition internally within a company.
  • Cutting a dividend can be interpreted very negatively by the market, as investors will assume the worst and expect future profits to decrease (hence, dividends are rarely cut once implemented).
  1. A company with $100 million in net income and a P/E multiple of 15x is considering raising $200 million in debt to pay out a one-time cash dividend. How would you decide if this is a good idea?: If we assume that the P/E multiple stays the same after the dividend and a cost of debt of 5%, the impact to shareholders is as follows:
  • Net income drops from $100 million to $90 million [($200 million new borrowing x 5%) = $10 million]
  • Equity value drops from $1,500 million (15 x $100 million) to $1,350 million (15. x $90 million) Although there's a tax impact since interest is mostly deductible, it can be ignored for interviewing purposes. That's a $150 million drop in equity value. However, shareholders are immediately getting $200 million.So ignoring any tax impact, there's a net benefit of $50 million ($200 million - $150 million) to shareholders. The assumptions we made about taxes, the cost of debt and the multiple staying the same all affect the result. If any of those variables were different - for example, if the cost of debt was higher - the equity value might be wiped out in light of this move. A key assumption in getting the answer here was that P/E ratios would remain the same at 15x. A company's P/E multiple is a function of its growth prospects, ROE, and cost of equity. Hence, borrowing more with no compensatory increase in investment or growth raises the cost of equity via a higher beta, which will pressure the P/E multiple down. While it appears based on our assumptions that this is a decent idea, it could easily

be a bad idea given a different set of assumptions. It's possible that borrowing for the sake of issuing dividends is unsustainable indefinitely because eventually, debt levels will rise to a point where the cost of capital and P/E ratios are adversely affected. Broadly, debt should support investments and activities that will lead to firm and shareholder value creation rather than extract cash from the business.

36. When would it be most appropriate for a company to distribute dividends?- : Companies that distribute dividends are usually low-growth with fewer profitable projects in their pipeline. Therefore, the management opts to pay out dividends to signal the company is confident in its long-term profitability and appeal to a different shareholder base (more specifically, long-term dividend investors).

  1. What is CAGR and how do you calculate it?: The compound annual growth rate ("CAGR") is the rate of return required for an investment to grow from its beginning balance to its ending balance. Put another way, CAGR is the annualized average growth rate. CAGR = (Ending Value / Beginning Value)^1/t - 1
  2. What is the difference between CAGR and IRR?: The compound annual growth rate (CAGR) and internal rate of return (IRR) are both used to measure the return on an investment. However, the calculation of CAGR involves only three inputs: the investment's beginning and ending value and the number of years. IRR, or the XIRR in Excel to be more specific, can handle more complex situations with the timing of the cash inflows and outflows (i.e., the volatility of the multiple cash flows) accounted for, rather than just smoothing out the investment returns. CAGR is usually for assessing historical data (e.g., past revenue growth), whereas IRR is used more often for investment decision-making.
  3. How would you evaluate the buy vs. rent decision in NYC?: - First, I would have to make assumptions to allow for a proper comparison, such as having enough upfront capital to make a down payment and the investment period being ten years.
  • Under the 1st option, I assume I buy and will have to pay the monthly mortgage, real estate tax, and maintenance fees (which will be offset by some tax deductions on interest and depreciation) during this investment period. Then, I'll assume that I could sell the property at a price that reflects the historical growth rate in real estate in NYC. Based on the initial and subsequent monthly outlays and the final inflow due to a sale, I can calculate my IRR and compare this IRR to the IRR from renting.
  • For the 2nd option, I would start by estimating the rental cost of comparable properties, factoring in rent escalations over ten years. Since there's no initial down-payment required, I would put that money to work elsewhere, such as an

a premium for being sold in the public markets with ease (called the "liquidity premium").

  1. Walk me through a DCF.: The most common approach to building a DCF is the unlevered DCF, which involves the following steps:
  2. Forecast Unlevered Free Cash Flows ("FCFF" or "UFCF"): First, unlevered free cash flows, which represent cash flows to the firm before the impact of leverage, should be forecast explicitly for a 5 to 10 year period.
  3. Calculate Terminal Value ("TV"): Next, the value of all unlevered FCFs beyond the initial forecast period needs to be calculated - this is called the terminal value. The two most common approaches for estimating this value are the growth in perpetuity approach and the exit multiple approach.
  4. Discount Stage 1 & 2 CFs to Present Value ("PV"): Since we are valuing the company at the current date, both the initial forecast period and terminal value need to be discounted to the present using the weighted average cost of capital ("WACC").
  5. Move from Enterprise Value’Equity Value: To get to equity value from enterprise value, we would need to subtract net debt and other non-equity claims. For the net debt calculation, we would add the value of non-operating assets such as cash or investments and subtract debt. Then, we would account for any other non-equity claims such as minority interest.
  6. Price Per Share Calculation: Then, to arrive at the DCF-derived value per share, divide the equity value by diluted shares outstanding as of the valuation date. For public companies, the equity value per share that our DCF just calculated can be compared to the current share price.
  7. Sensitivity Analysis: Given the DCF's sensitivity to the assumptions used, the last step is to create sensitivity tables to see how the assumptions used will impact the implied price per share.
  8. Conceptually, what does the discount rate represent?: The discount rate represents the expected return on an investment based on its risk profile (meaning, the discount rate is a function of the riskiness of the cash flows). Put another way, the discount rate is the minimum return threshold of an investment based on comparable investments with similar risks. A higher discount rate makes a company's cash flows less valuable, as it implies the investment carries a greater amount of risk, and therefore should be expected to yield a higher return (and vice versa).
  1. What is the difference between unlevered FCF (FCFF) and levered FCF (FCFE)?: Unlevered FCF: FCFF represents cash flows a company generates from its core operations after accounting for all operating expenses and investments. To calculate FCFF, you start with EBIT, which is an unlevered measure of profit because it excludes interest and any other payments to lenders. You'll then tax effect EBIT, add back non-cash items, make working capital adjustments, and subtract capital expenditures to arrive at FCFF. Tax-affected EBIT is often referred to as Net Operating Profit After Taxes ("NOPAT") or Earnings Before Interest After Taxes ("EBIAT"). FCFF = EBIT × (1-TaxRate) + D&A - Changes in NWC - Capex Levered FCF: FCFE represents cash flows that remain after payments to lenders since interest expense and debt paydown are deducted. These are the residual cash flows that belong to equity owners. Instead of tax-affected EBIT, you start with net income, add back non-cash items, adjust for changes in working capital, subtract capex, and add cash inflows/(outflows) from new borrowings, net of debt paydowns. FCFE = Cash from Operations - Capex - Debt Principal Payment
  2. What is the difference between the unlevered DCF and the levered DCF?: - Unlevered DCF: The unlevered DCF discounts the unlevered FCFs to arrive directly at enterprise value. When you have a present value, add any non-operating assets such as cash and subtract any financing-related liabilities such as debt to get to the equity value.The appropriate discount rate for the unlevered DCF is the weighted average cost of capital (WACC) because the rate should reflect the riskiness to both debt and equity capital providers since UFCFs are cash flows that belong to debt and equity providers. Levered DCF: The levered DCF approach, on the other hand, arrives at equity value directly. First, the levered FCFs are forecasted and discounted, which gets you to equity value directly. The appropriate discount rate on LFCFs is the cost of equity since these cash flows belong solely to equity owners and should thus reflect the risk of equity capital. If you wanted to get to enterprise value, you would add back net debt. The levered and unlevered DCF method should theoretically lead to the same enterprise value and equity value, but in practice, it's very difficult to get them to be precisely equal.
  3. What is the appropriate cost of capital when unlevered FCF (FCFF) and levered FCF (FCFE)?: When doing an unlevered DCF, the weighted average cost of capital (WACC) is the correct cost of capital to use because it reflects the cost of

Equity Risk Premium (ERP) = Expected Market Return Risk Free Rate

  1. Explain the concept of beta (²):. Beta measures the systematic (i.e., non-di- versifiable) risk of a security compared to the broader market. Said another way, beta equals the covariance between expected returns on the asset and the market, divided by the variance of expected returns on the market. A company with a beta of 1.0 would expect to see returns consistent with the overall stock market returns. If the market has gone up 10%, the company should see a return of 10%. A company with a beta of 2.0 would expect a return of 20% if the market had gone up 10%. Beta/Market Sensitivity Relationship ² = 0 N’o Market Sensitivity ² < 1L’ow Market Sensitivity ² > 1 H’igh Market Sensitivity ² < 0 N’egative Market Sensitivity
  2. What is the difference between systematic risk and unsystematic risk?: - Systematic Risk: Otherwise known as undiversifiable risk (or market risk), this is the risk inherent within the entire equity market rather than specific to a particular company or industry. This type of risk is unavoidable and cannot be mitigated through diversification. Unsystematic Risk: In contrast, unsystematic risk is the company-specific (or in- dustry) risk that can be reduced through portfolio diversification. The effects of diversification will be more profound when the portfolio contains investments in different asset classes, industries, and geographies.
  3. Does a higher beta translate into a higher or lower valuation?: A company with a high beta suggests more risk and will exhibit higher volatility than the market (i.e., higher sensitivity to market fluctuations). Thus, a higher discount rate will be used by investors to value the company's cash flows, which directly leads to a lower valuation, all else being equal.
  4. What type of sectors would have higher or lower betas?: A useful question to ask yourself when assessing beta is: "Would consumers require (or demand) thisproduct or service during a recession?" High Beta: A beta of >1 would mean the industry is highly cyclical and be more volatile than the broad market. For example, the automobile, semiconductors, and construction industry have higher betas since most consumers only purchase cars

and new homes during positive economic growth. Low Beta: A beta of < 1 suggests the security is less volatile than the broad market. Consumer product stores that sell necessary, everyday goods such as toiletries and personal hygiene products would have a low beta. Other sectors with low betas are hospitals/healthcare facilities and utilities, which provide essential goods and services required by consumers regardless of the prevailing economic climate.

  1. What are the benefits of the industry beta approach?: The industry ²ap- proach looks at the ²of a comparable peer group to the company being valued and then applies this peer-group derived beta to the target. The benefits are that company-specific noise is eliminated, which refers to distorting events that could cause the correlation shown in its beta to be less accurate. So the peer-group derived beta is "normalized" since it takes the average of the unlevered betas of comparable businesses and then relevers it at the target capital structure of the company being valued. The implied assumption is that the compa- ny's business risk will converge with its peer group over the long run. This approach also enables one to arrive at an industry-derived beta for private companies that lack readily observable betas. To perform a DCF analysis for a private company, the industry beta approach would be required as privately-held companies don't have readily observable betas.
  2. What are the flaws of regression betas?: 1. Backward Looking: The standard procedure to estimate the beta is through a regression model that compares the historical market index returns and company returns, in which the slope of the regression corresponds to the beta of the stock. However, this past performance (and correlation) may not be an accurate indicator of the stock's future performance.
  3. Large Standard Error: The regression model is sensitive to the assumptions used, such as the index chosen to be the proxy for the market return. There are also company-specific events that can cause deviations that are not indicative of a company's true correlation with the market.
  4. Constant Capital Structure: The regression beta reflects the averaged past D/E ratios instead of the current leverage in the company's capital structure. The amount of leverage used by a company often directly relates to its maturity, so this can be argued to be a flawed assumption for forecasting purposes, especially when considering beta's relationship with debt.
  5. What is the impact of leverage on the beta of a company?: If a company's capital structure has no leverage, its levered beta (or equity beta) would be equal to its unlevered beta (or asset beta), reflecting only business-specific risk. The removal

WACC continues to decrease until the optimal capital structure is reached. But once this threshold is surpassed, the cost of potential financial distress off sets the tax advantages of debt, and the WACC will reverse course and begin an upward trajectory as the risk to all debt and equity stakeholders increases. Besides the risk of a company becoming overburdened with leverage, debt also comes with more constraints (i.e., covenants) that restrict activity and prevent them from exceeding certain leverage ratios or maintaining a coverage ratio above a certain threshold.

  1. What is the difference between WACC and IRR?: Internal Rate of Return: The IRR is the rate of return on a project's expenditures. Given a beginning value and ending value, the IRR is the implied interest rate at which the initial capital investment would have to grow to reach the ending value. Alternatively, it's defined as the discount rate on a stream of cash flows leading to a net present value (NPV) of 0. Weighted Average Cost of Capital: The WACC (or cost of capital) is the average minimum required internal rate of return for both debt and equity providers of capital. Thus, an IRR that exceeds the WACC is an often-used criterion for deciding whether a project should be pursued.
  2. Which would have more of an impact on a DCF, the discount rate or sales growth rate?: The discount rate and the sales growth rate will be sensitized in a proper DCF model, but the discount rate's impact would far exceed that of operational assumptions such as the sales growth rate.
  3. How is the terminal value calculated?: There are two common approaches to calculate the terminal value ("TV"):
  4. Growth in Perpetuity Approach: Often called the Gordon Growth method, the growth in perpetuity approach calculates the terminal value by assuming a perpetual growth rate on cash flows after the explicit forecast period and then inserting this assumption into the static perpetuity formula.
  5. Exit Multiple Approach: The exit multiple approach calculates the terminal value by applying a multiple assumption on a financial metric (usually EBITDA) in the terminal year. The multiple reflects the multiple of a comparable company in a mature state. 70. Why is it necessary to discount the terminal value back to the present?- : Under both approaches, the terminal value represents the present value of the company's cash flows in the final year of the 1st stage of the explicit forecast period right before entering the perpetuity stage. The TV calculated is the present value of a growing perpetuity at the very end of the stage 1 projection of cash flows.

Thus, this future value must be discounted back to its present value (PV) since the DCF is based on what a company is worth today, the current date of the valuation.

  1. For the perpetuity approach, how do you determine the long-term growth rate?: The long-term growth rate is the rate that the company will grow into perpe- tuity. That being said, it should range somewhere between 1% to 3% (sometimes up to 5%). Often, GDP or the risk-free rate are proxies for g. This growth rate must reflect the steady-state period when growth has slowed down to a sustainable rate. A hypothetical question to ask would be: "Can this company grow at X% for the next hundred years?" If not, then the perpetuity growth rate should be adjusted downward to be more realistic.
  2. What is the argument against using the exit multiple approach in a DCF?: In theory, a DCF is an intrinsic, cash-flow based valuation method independent of the market. By using the exit multiple approach, relative valuation is being brought into the valuation. However, the exit multiple approach is widely used in practice due to being easier to discuss and defend in terms of justifying the assumptions used.
  3. What is the purpose of using a mid-year convention in a DCF model?: By using the mid-year convention, we are treating the projected cash flows as if they're generated at the midpoint of the given period. Without this mid-year adjustment, the DCF implicitly assumes that all cash flows are being received at the end of the year. This would be inaccurate since cash flows are generated steadily throughout the year, depending on the industry. The compromise is to use a mid-year convention that assumes the CFs are received in the middle of the year. Since the projected cash flows are received earlier, the implied valuation of the company would increase because of the earlier received cash flows. For example, if the cash flow you're discounting is Year 5 and the discount factor is 5, the mid-year convention would use a discount factor of 4.5 since we are assuming half a year has passed before the cash flow is generated.
  4. Could you give me an example of when the mid-year convention might be inappropriate?: While the mid-year convention in a DCF is standard practice, it may be inaccurate for highly seasonal companies. Many retail companies experience strong seasonal patterns in demand, and sales are disproportionally received in the 3rd and 4th quarters. This is particularly the case for retailers that have a niche in winter clothing. For example, the mid-year convention may be an inappropriate adjustment for Canada Goose, a Canadian company that focuses primarily on winter clothing. The unad- justed, period-end assumption may be more appropriate in this scenario.
  5. How would raising additional debt impact a DCF analysis?: The enterprise value based on an unlevered DCF should theoretically remain relatively unchanged since the DCF is capital structure neutral. But if the debt raised changed the