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Top 100+ Discounted Cash Flow (dcf) Interview Questions And Answers - May 29, 2020

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Top 100+ Discounted Cash Flow (dcf) Interview Questions And Answers

Question 1. Walk Me Through A Dcf?

Answer :

"A DCF values a organization based totally at the Present Value of its Cash Flows and the Present Value of its Terminal Value.

First, you venture out a corporation's financials the usage of assumptions for sales increase, costs and Working Capital; then you get right down to Free Cash Flow for every yr, which you then sum up and discount to a Net Present Value, based totally for your cut price price - commonly the Weighted Average Cost of Capital.

Once you have the prevailing fee of the Cash Flows, you decide the organisation's Terminal Value, the use of both the Multiples Method or the Gordon Growth Method, and then additionally cut price that back to its Net Present Value the usage of WACC.

Finally, you add the two collectively to decide the company's Enterprise Value."

Question 2. Walk Me Through How You Get From Revenue To Free Cash Flow In The Projections?

Answer :

Subtract COGS and Operating Expenses to get to Operating Income (EBIT). Then, multiply by (1 - Tax Rate), add back Depreciation and other non-cash prices, and subtract Capital Expenditures and the trade in Working Capital.

Note: This gets you to Unlevered Free Cash Flow since you went off EBIT instead of EBT. You may want to confirm that this is what the interviewer is inquiring for.

Financial Planning Interview Questions
Question three. What's An Alternate Way To Calculate Free Cash Flow Aside From Taking Net Income, Adding Back Depreciation, And Subtracting Changes In Operating Assets / Liabilities And Capex?

Answer :

Take Cash Flow From Operations and subtract CapEx - that gets you to Levered Cash Flow. To get to Unlevered Cash Flow, then you want to add back the tax-adjusted Interest Expense and subtract the tax-adjusted Interest Income.

Question four. Why Do You Use 5 Or 10 Years For Dcf Projections?

Answer :

That's generally approximately as a ways as you could reasonably are expecting into the future. Less than five years would be too quick to be beneficial, and over 10 years is too difficult to expect for most corporations.

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Question 5. What Do You Usually Use For The Discount Rate?

Answer :

Normally you use WACC (Weighted Average Cost of Capital), though you might additionally use Cost of Equity relying on how you've got installation the DCF.

Financial Reporting and Analysis Interview Questions
Question 6. How Do You Calculate Wacc?

Answer :

The method is: Cost of Equity * (% Equity) + Cost of Debt * (% Debt) * (1 - Tax Rate) + Cost of Preferred * (% Preferred).

In all instances, the chances seek advice from how a great deal of the business enterprise's capital shape is taken up by means of each component.

For Cost of Equity, you could use the Capital Asset Pricing Model (CAPM - see the subsequent question) and for the others you generally study comparable groups/debt issuances and the hobby rates and yields issued with the aid of comparable groups to get estimates.

Question 7. How Do You Calculate The Cost Of Equity?

Answer :

Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium

The chance-loose fee represents how a whole lot a ten-year or 20-year US Treasury have to yield; Beta is calculated primarily based at the "riskiness" of Comparable Companies and the Equity Risk Premium is the % with the aid of which stocks are anticipated to out-carry out "threat-much less" property.
Normally you pull the Equity Risk Premium from a booklet referred to as Ibbotson's.

Note: This formula does now not tell the complete tale. Depending on the bank and the way precise you want to be, you may also upload in a "size premium" and "enterprise top class" to account for how plenty a enterprise is anticipated to out-perform its peers is in line with its market cap or enterprise.

Small enterprise stocks are anticipated to out-carry out massive company shares and certain industries are predicted to out-perform others, and those rates reflect those expectations.

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Question eight. How Do You Get To Beta In The Cost Of Equity Calculation?

Answer :

You look up the Beta for every Comparable Company (normally on Bloomberg), un-lever every one, take the median of the set after which lever it based totally for your employer's capital structure. Then you use this Levered Beta inside the Cost of Equity calculation.

For your reference, the formulas for un-levering and re-levering Beta are under:
Un-Levered Beta = Levered Beta / (1 + ((1 - Tax Rate) x (Total Debt/Equity))) Levered Beta = Un-Levered Beta x (1 + ((1 - Tax Rate) x (Total Debt/Equity)))

Question nine. Why Do You Have To Un-lever And Re-lever Beta?

Answer :

Again, maintain in mind our "apples-to-apples" theme. When you look up the Betas on Bloomberg (or from something supply you're using) they'll be levered to mirror the debt already assumed by every organisation.

But each employer's capital shape is one-of-a-kind and we want to observe how "volatile" a corporation is irrespective of what % debt or equity it has.

To get that, we want to un-lever Beta whenever.

But on the give up of the calculation, we want to re-lever it due to the fact we need the Beta used in the Cost of Equity calculation to mirror the true hazard of our company, thinking of its capital structure this time.

Financial Accounting&Financial Statement Analysis Interview Questions
Question 10. Let's Say That You Use Levered Free Cash Flow Rather Than Unlevered Free Cash Flow In Your Dcf - What Is The Effect?

Answer :

Levered Free Cash Flow gives you Equity Value as opposed to Enterprise Value, since the cash waft is handiest available to fairness buyers (debt investors have already been "paid" with the interest payments).

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Question eleven. If You Use Levered Free Cash Flow, What Should You Use As The Discount Rate?

Answer :

You would use the Cost of Equity as opposed to WACC considering the fact that we are now not worried with Debt or Preferred Stock in this case - we're calculating Equity Value, no longer Enterprise Value.

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Question 12. How Do You Calculate The Terminal Value?

Answer :

You can both practice an exit a couple of to the business enterprise's Year 5 EBITDA, EBIT or Free Cash Flow (Multiples Method) or you may use the Gordon Growth technique to estimate its price based on its growth rate into perpetuity.

The method for Terminal Value using Gordon Growth is: Terminal Value = Year 5 Free Cash Flow * (1 + Growth Rate) / (Discount Rate - Growth Rate).

Financial Planning Interview Questions
Question 13. Why Would You Use Gordon Growth Rather Than The Multiples Method To Calculate The Terminal Value?

Answer :

In banking, you almost always use the Multiples Method to calculate Terminal Value in a DCF. It's an awful lot easier to get appropriate facts for go out multiples in view that they are based on Comparable Companies - choosing a long-time period growth price, through assessment, is continually a shot in the darkish.

However, you might use Gordon Growth if you have no precise Comparable Companies or when you have purpose to agree with that multiples will change drastically in the industry several years down the street. For instance, if an enterprise may be very cyclical you is probably better off the use of long-time period growth rates as opposed to go out multiples.

Question 14. What's An Appropriate Growth Rate To Use When Calculating The Terminal Value?

Answer :

Normally you operate the u . S . A .'s long-term GDP growth price, the rate of inflation, or some thing further conservative.

For corporations in mature economies, an extended-term increase rate over 5% would be pretty aggressive on the grounds that most evolved economies are growing at less than 5% in keeping with year.

Question 15. How Do You Select The Appropriate Exit Multiple When Calculating Terminal Value?

Answer :

Normally you examine the Comparable Companies and select the median of the set, or some thing close to it.

As with nearly anything else in finance, you always show a number of go out multiples and what the Terminal Value looks as if over that variety instead of choosing one particular wide variety.

So if the median EBITDA a couple of of the set had been 8x, you might show a range of values the usage of multiples from 6x to 10x.

Financial Statement Interview Questions
Question sixteen. Which Method Of Calculating Terminal Value Will Give You A Higher Valuation?

Answer :

It's hard to generalize because both are fairly dependent on the assumptions you are making. In trendy, the Multiples Method may be greater variable than the Gordon Growth method due to the fact go out multiples generally tend to span a much broader range than possible long-term growth prices.

Question 17. What's The Flaw With Basing Terminal Multiples On What Public Company Comparables Are Trading At?

Answer :

The median multiples may additionally trade substantially in the next five-10 years so it can not be accurate by means of the quit of the length you're looking at. This is why you commonly study a huge range of multiples and do a sensitivity to see how the valuation adjustments over that variety.

This method is in particular complicated with cyclical industries (e.G. Semiconductors).

Financial Ratio Interview Questions
Question 18. How Do You Know If Your Dcf Is Too Dependent On Future Assumptions?

Answer :

The "widespread" solution: if notably greater than 50% of the company's Enterprise Value comes from its Terminal Value, your DCF is probably too dependent on destiny assumptions.

In truth, almost all DCFs are "too depending on destiny assumptions" - it's truly pretty rare to look a case in which the Terminal Value is much less than 50% of the Enterprise Value.

But while it gets to be inside the eighty-ninety% range, you understand that you may need to re-think your assumptions.

Financial Reporting and Analysis Interview Questions
Question 19. What's The Relationship Between Debt And Cost Of Equity?

Answer :

More debt manner that the corporation is extra risky, so the enterprise's Levered Beta can be better - all else being same, extra debt would increase the Cost of Equity, and less debt would decrease the Cost of Equity.

Question 20. Cost Of Equity Tells Us What Kind Of Return An Equity Investor Can Expect For Investing In A Given Company - But What About Dividends? Shouldn't We Factor Dividend Yield Into The Formula?

Answer :

Dividend yields are already factored into Beta, due to the fact Beta describes returns in excess of the marketplace as a whole - and people returns include dividends.

Financial Analyst Interview Questions
Question 21. How Can We Calculate Cost Of Equity Without Using Capm?

Answer :

There is an trade formula:

Cost of Equity = (Dividends in step with Share / Share Price) + Growth Rate of Dividends

This is much less not unusual than the "standard" method but occasionally you operate it for agencies wherein dividends are extra critical or whilst you lack right information on Beta and the alternative variables that go into calculating Cost of Equity with CAPM.

Question 22. Two Companies Are Exactly The Same, But One Has Debt And One Does Not - Which One Will Have The Higher Wacc?

Answer :

 Interest on debt is tax-deductible (for this reason the (1 - Tax Rate) multiplication within the WACC formulation).
Debt is senior to equity in a organization's capital structure - debt holders could be paid first in a liquidation or financial disaster.
Intuitively, interest costs on debt are typically lower than the Cost of Equity numbers you notice (usually over 10%). As a result, the Cost of Debt part of WACC will make contributions less to the full discern than the Cost of Equity component will.
 However, the above is true most effective to a certain point. Once a corporation's debt goes up high sufficient, the hobby price will upward thrust dramatically to reflect the extra danger and so the Cost of Debt could begin to growth - if it gets high sufficient, it would grow to be higher than Cost of Equity and additional debt could growth WACC.
It's a "U-shape" curve wherein debt decreases WACC to a degree, then starts growing it.

Question 23. Which Has A Greater Impact On A Company's Dcf Valuation - A 10% Change In Revenue Or A 1% Change In The Discount Rate?

Answer :

You need to start via announcing, "it depends" however most of the time the 10% distinction in revenue could have greater of an effect.

That exchange in sales doesn't have an effect on handiest the modern-day year's revenue, however also the revenue/EBITDA far into the destiny or even the terminal cost.

Cashier Interview Questions
Question 24. What About A 1% Change In Revenue Vs. A 1% Change In The Discount Rate?

Answer :

In this example the bargain price is probable to have a larger effect at the valuation, even though the right solution must start with, "It ought to go either manner, however most of the time..."

Financial Management Interview Questions
Question 25. How Do You Calculate Wacc For A Private Company?

Answer :

This is complex because private groups don't have market caps or Betas. In this situation you would most probable simply estimate WACC based on work performed by auditors or valuation experts, or based on what WACC for similar public organizations is.

Question 26. What Should You Do If You Don't Believe Management's Projections For A Dcf Model?

Answer :

You can take a few exceptional methods:

You can create your personal projections.
You can adjust management's projections downward to cause them to greater conservative.
You can display a sensitivity desk based on exceptional increase prices and margins and show the values assuming managements' projections and assuming a greater conservative set of In truth, you would likely do all of those if you had unrealistic projections.
Financial Modelling Interview Questions
Question 27. Why Would You Not Use A Dcf For A Bank Or Other Financial Institution?

Answer :

Banks use debt otherwise than other corporations and do now not re-make investments it inside the commercial enterprise -they use it to create products as an alternative. Also, hobby is a essential a part of banks' business fashions and running capital takes up a big part of their Balance Sheets - so a DCF for a financial organization would now not make a lot feel. For monetary establishments, it is greater not unusual to use a dividend cut price model for valuation functions.

Financial Accounting&Financial Statement Analysis Interview Questions
Question 28. What Types Of Sensitivity Analyses Would We Look At In A Dcf?

Answer :

Example sensitivities:

Revenue Growth vs. Terminal Multiple
EBITDA Margin vs. Terminal Multiple
Terminal Multiple vs. Discount Rate
Long-Term Growth Rate vs. Discount Rate
And any mixture of those (besides Terminal Multiple vs. Long-Term Growth Rate, which could make no experience).




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