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In a DCF valuation, what is the primary purpose of estimating the cost of capital?
In a DCF valuation, what is the primary purpose of estimating the cost of capital?
- To determine the terminal value of the company
- To determine the growth rate of cash flows
- To determine the present value of cash flows
- To determine the discount rate for cash flows (correct)
Which of the following is a consideration when estimating cash flows for a DCF valuation?
Which of the following is a consideration when estimating cash flows for a DCF valuation?
- Future expectations and forecasted growth (correct)
- Historical financial performance only
- Current market prices of comparable companies
- Industry averages and benchmarks
What is the difference between nominal and real cash flows?
What is the difference between nominal and real cash flows?
- Nominal cash flows are in current dollars, real cash flows are in constant dollars (correct)
- Nominal cash flows are based on historical data, real cash flows are based on forecasted data
- Nominal cash flows are before tax, real cash flows are after tax
- Nominal cash flows are used for equity valuation, real cash flows are used for debt valuation
What is the primary purpose of estimating a terminal growth rate in a DCF valuation?
What is the primary purpose of estimating a terminal growth rate in a DCF valuation?
When estimating the cost of capital, which of the following is NOT a factor to consider?
When estimating the cost of capital, which of the following is NOT a factor to consider?
Which of the following would be used to estimate the discount rate in a DCF valuation?
Which of the following would be used to estimate the discount rate in a DCF valuation?
What is the primary advantage of using a DCF valuation?
What is the primary advantage of using a DCF valuation?
When estimating cash flows for a DCF valuation, which of the following should be excluded?
When estimating cash flows for a DCF valuation, which of the following should be excluded?
What is the terminal growth rate of Darden Restaurants, Inc (DRI) expected to be?
What is the terminal growth rate of Darden Restaurants, Inc (DRI) expected to be?
When estimating cash flow to equity, which earnings should be considered?
When estimating cash flow to equity, which earnings should be considered?
What is the purpose of estimating the cost of capital in a discounted cash flow model?
What is the purpose of estimating the cost of capital in a discounted cash flow model?
What is the main difference between nominal and real cash flows?
What is the main difference between nominal and real cash flows?
What is the purpose of estimating cash flow in a discounted cash flow model?
What is the purpose of estimating cash flow in a discounted cash flow model?
When estimating cash flow to the firm, which earnings should be considered?
When estimating cash flow to the firm, which earnings should be considered?
What is the relationship between the cost of capital and the discount rate in a discounted cash flow model?
What is the relationship between the cost of capital and the discount rate in a discounted cash flow model?
What is free cash flow (FCF) in a discounted cash flow model?
What is free cash flow (FCF) in a discounted cash flow model?
What is the primary purpose of estimating the Free Cash Flow to Equity (FCFE)?
What is the primary purpose of estimating the Free Cash Flow to Equity (FCFE)?
What is the effect of an increase in working capital on the calculation of Free Cash Flow to the Firm (FCFF)?
What is the effect of an increase in working capital on the calculation of Free Cash Flow to the Firm (FCFF)?
What is the relationship between the cost of capital and the discount rate in a capital budgeting project?
What is the relationship between the cost of capital and the discount rate in a capital budgeting project?
How does a decrease in a firm's debt affect the calculation of Free Cash Flow to Equity (FCFE)?
How does a decrease in a firm's debt affect the calculation of Free Cash Flow to Equity (FCFE)?
What is the primary difference between nominal and real cash flows?
What is the primary difference between nominal and real cash flows?
What is the purpose of estimating the terminal growth rate in a capital budgeting project?
What is the purpose of estimating the terminal growth rate in a capital budgeting project?
How does an increase in capital expenditures affect the calculation of Free Cash Flow to the Firm (FCFF)?
How does an increase in capital expenditures affect the calculation of Free Cash Flow to the Firm (FCFF)?
What is the primary purpose of estimating the discount rate in a capital budgeting project?
What is the primary purpose of estimating the discount rate in a capital budgeting project?
What is the primary consideration when selecting a discount rate for a cash flow?
What is the primary consideration when selecting a discount rate for a cash flow?
If the cash flows being discounted are nominal cash flows, what type of discount rate should be used?
If the cash flows being discounted are nominal cash flows, what type of discount rate should be used?
What is the formula for estimating the cost of equity (Ke)?
What is the formula for estimating the cost of equity (Ke)?
What should be used to discount cash flows to the firm?
What should be used to discount cash flows to the firm?
What is the primary difference between the cost of equity and the cost of debt?
What is the primary difference between the cost of equity and the cost of debt?
When estimating the cost of equity for a company with international operations, what should be considered?
When estimating the cost of equity for a company with international operations, what should be considered?
What is the purpose of estimating the cost of equity?
What is the purpose of estimating the cost of equity?
What is the relationship between the cost of equity and the beta of the company?
What is the relationship between the cost of equity and the beta of the company?
In a two-stage DCF model, the terminal growth rate is used to estimate the present value of cash flows beyond the forecast period. Which of the following statements about the terminal growth rate is true?
In a two-stage DCF model, the terminal growth rate is used to estimate the present value of cash flows beyond the forecast period. Which of the following statements about the terminal growth rate is true?
When estimating cash flows for a DCF valuation, which of the following is an example of a nominal cash flow?
When estimating cash flows for a DCF valuation, which of the following is an example of a nominal cash flow?
What is the primary purpose of estimating the cost of capital in a DCF valuation?
What is the primary purpose of estimating the cost of capital in a DCF valuation?
Which of the following methods is commonly used to estimate the cost of capital for a company?
Which of the following methods is commonly used to estimate the cost of capital for a company?
When estimating the discount rate in a DCF valuation, which of the following factors should be considered?
When estimating the discount rate in a DCF valuation, which of the following factors should be considered?
Which of the following cash flows should be excluded when estimating cash flows for a DCF valuation?
Which of the following cash flows should be excluded when estimating cash flows for a DCF valuation?
In a DCF valuation, what is the purpose of estimating the present value of cash flows?
In a DCF valuation, what is the purpose of estimating the present value of cash flows?
Which of the following is a common approach to forecasting cash flows in a DCF valuation?
Which of the following is a common approach to forecasting cash flows in a DCF valuation?
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Study Notes
Discounted Cash Flow (DCF) Models
- DCF models estimate the value of a company based on the present value of its future cash flows.
Estimating Cash Flow
- Free cash flow (FCF) represents the cash available for a company to repay creditors or pay dividends and interest to investors.
- Estimate the current earnings of the firm:
- If looking at cash flows to equity, look at earnings after interest expenses - i.e. net income.
- If looking at cash flows to the firm, look at operating earnings after taxes.
- Consider how much the firm invested to create future growth:
- If the investment is not expensed, it will be categorized as capital expenditures.
Estimating Growth Rate
- Growth rate is a key input in DCF models.
- Growth rate can be estimated based on historical data, industry trends, or management's guidance.
Estimating Cost of Capital
- The cost of capital is the rate of return required by investors.
- The cost of capital is a function of the riskiness of the company and the type of cash flows being discounted.
- Cost of equity (Ke):
- Ke = Rf + β x (Rm-Rf)
- Ke = Rf + CRP + Beta (Mature ERP)
- Cost of debt (Kd):
- The cost of debt is the rate at which the company can borrow at currently.
Valuation Process
- Valuation is based on expected future performance, not past performance.
- Valuation involves:
- Analysis of the economic environment.
- Analysis of the industry.
- Analysis of the financial history and prospects of the business.
- Forecasting the future operations of the business.
- Applying acceptable valuation methods.
DCF Formula
- Stock Value = Σ (CFt / (1+r)^t)
Two-Stage DCF Valuation Model
- Forecast period: typically 5-10 years.
- Terminal year: the year after the forecast period.
- Cash flows can be forecast for any number of years.
- Discount rate: 1/(1+r)^t
Practice Questions
- Practice 1:
- Expected dividend growth rate: 12% + 2% = 14%.
- Required rate of return: 14%.
- Growth rate: 4% pa.
- Practice 2:
- Current dividend: $2.00.
- Required rate of return: 14%.
- Dividend growth pattern: 3% for 3 years, 2% afterwards.
Other Concepts
- Net income: earnings after interest expenses and taxes.
- Depreciation and amortization: non-cash expenses.
- Capital expenditures: investments in the company.
- Changes in working capital: changes in current assets and liabilities.
- Free cash flow to equity (FCFE): cash available for distribution to equity investors.
- Principal debt repayments: repayments of principal debt.
- New debt issues: issuance of new debt.
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