DCF ANALYSIS

What is higher? Cost of equity or the cost of debt and why?

Cost of equity is always higher than the cost of debt this is primarily because the debt holders
are paid to the equity holders, whenever free cash flow is generated the first person to receive
the cash is a debt holders, after debt holders have been paid if there is a remaining value it is
paid to the preferred shareholders and after that, if any values remaining the company has a
call whether it wants to invest in new projects or pay to the cost of equity pay to the equity
holder, so equity holders are usually last inline to receive the dividends. So hence require a
larger return because they are taking additional risk people are being paid before them hence
that taking an additional risk and hence, they require an additional return for them. An
additional return means a higher return on equity, a high return on equity from a point of you
culminates into higher cost of equity for them. Also, the fact that debt is tax-deductible makes
it cheaper on an after-tax place.

Walk me through a typical DCF model.

A DCF model or a discounted cash flow model is a model that is used to ascertain the value
of a company by discounting the cash flows to the company at an appropriate cost of capital.
So let me assume that we are discounting the cash flows to the firm, so we will use a WACC
that is a weighted average cost of capital to discount a free cash flows to the firm to the
present value to determine the value of the company. So just walk you through a DCF model.
We start with the NOPAT; we get that by multiplying EBIT into 1 minus tax rate once we get
that NOPAT, we add all the non-cash expenses that were subtracted initially in arriving and
that NOPAT. So, we add depreciation and amortization we add stock-based compensation we
remove any working capital investments after all this has been done, any additional cash that
has been left is used to invest in long fixed capital investment models. Once that has been
done the value that is remaining is known as a cash-free cash flow to the firm. So why free
cash flow it means that the firm has full Liberty in determining what to do with this cash
flows basically the company uses these cash flow to first pay the debt holders, anyways, you
get the free cash flow your discount that using inappropriately determined cost of return that
is WACC and you find the present value of all the cash flows till now but you cannot assume
that the cash flows will grow into Infinity forever so at the point in time, generally after
5 years. You assume that a company is going to grow at a stable growth rate of cross to 5 to
6% depending on the economy in with the company operates and then you are going
to calculate the terminal value using either the Gordon growth formula or by using
the multiple. Once you have the terminal value you can also discount that to the present
and add the first initial stage one cash flow so terminal value to create the total value which is
known as enterprise value, from this enterprise value you subtract the net debt you subtract
the net debt to arrive at the cash at the equity value for the company. Once you have the
equity value for the company you divide that value by dilute number of shares outstanding to
find the value of the equity per share that is the value of a per-share price, once you have that
you compare that with the currently traded share in the market and take a call whether you
want to go long that is buy the share or whether you want to go short that is sell a share, this
is the typical working of a DCF model.

How does dividend payment and share repurchase affect FCFE?

Short ans is that Dividend share repurchases or share issues have no effect on FFF and FCFE,
the reason is very straightforward. FCFF and FCFE represent a cash flows available to
investors and shareholders respectively Before any payout decisions dividend share
repurchases and share this is on the other hand represent uses of those cash flows as such this
financial financing decisions don't affect the level of cash flows available. Hence, dividend
share repurchases or share if you will not affect in any way the FCFE of the company.

Explain Miller and Modigliani hypothesis on capital structure of a company.

Miller and Modigliani were two scientists who framed hypothesis based on the capital
structure of the company. The form two propositions and in both these propositions they had
two sub propositions. So whenever you there they have asked a question like this, it is better
to re questions and ask that which proposition do you want me to explain it to you, if they tell
your particular proposition then it's fine, if not, then you have to explain all the propositions
in short. So I am assuming that we have to assume all the propositions in short, so I will
explain the same. So Miler and Modigliani were two scientists gave hypothesis on the capital
structure of the company. The first opposition was that the capital structure is irrelevant
basically, they prove that the value of a firm is unaffected by the capital structure, however in
this, so hypothesis that assume that there is no tax so even if you take a 100% equity or 100%
debt the value of the company won't change. There proposition two with no taxes states that
the cost of equity increases linearly as a company increases its proportion of debt financing.
Again we have assumed no taxes over here, no cost of bankrupt in anything. Basically what
this says is that as companies increases the use of debt, the risk to equity holders increases
which in turn increases the cost of equity. Therefore the benefit of using a large proportion of
debt as a cheaper source of financing or offset by the rising cost of equity resulting in no
change in the firms weighted average cost of capital. Miller and Modigliani is proposition
one with taxes states that if we maintain the other assumptions, the value of a company
increases with increasing level of debt and the optimal capital structure is achieved at 100%
debt. The proposition two with taxes states that the value of a firm is maximized the point
where the WACC is minimised and the WACC is minimised at the point where debt is 100%
of the company is capital structure. 

What is the football field analysis?

Football field analysis is a pictorial representation of the different values achieved using the
valuation methods used it give the range of the different value that have been achieved using
the different valuation method that are available at the disposal. It is a good method for us to
understand the highest value that is being generated and the lowest value as well as a typical
range that these methods are generating.

What is WACC and how do you calculate it?

WACC is weighted average cost of capital so as a name suggest it is the weighted average of

a different cost of capital, the different cost of capital the company are the cost of debt in the
cost of equity. The cost of debt can be calculated by looking at the interest rate on the
market value of the bond and a company issues just one way, the market value the cost of
equity can be ascertained using the CAPM method. Once you have the cost of debt and the
cost of equity you just need the market value of debt and equity to calculate the relative
proportion of debt and equity in its capital structure then use a formula where you multiply
the market value of equity in either cost of equity and you multiply the market value of debt
by the after-tax cost of debt to find a weighted average cost of capital, more risky the firm
more will be the WACC, less risky the firm less will be the WACC.

What is beta?

Explain the concept of levered and unlevered beta. So the pure textbook definition of beta is
that beta is a measure of systematic risk of the company that is it measures the amount of
undiversifiable risk of a company. Beta is a measure of the volatility of the stock with respect
to the market a beta of one assumes no risk beta greater than one means that the stock is
more volatile with respect to the index and hence should be traded in carefully. A beta
less then one thing if I slow volatility and a low-risk stock. Regration beta is generally used
to calculate the beta but it suffers from a lot of shortcomings hence we introduced the concept
of levered and unlevered betas. Leverage is a very important part of determinant of beta but
we cannot use that to compare me beta across firms because different firm some different
leverage and hence different beta. So we unlevered the beta of the peers by using the
formula beta levered divided by 1 + 1 - tax rate into debt by equity. Once we have the
unlevered beta for all the firms, we take an average and we reliever that using the debt to
equity ratio of the subject company in consideration and that's how we attend the levered beta
for the set company that we are more interested in. 

Some follow-up question that can be asked depending on your own the answer that you gave
like for example, when I said that cost of equity is calculated using CAPM. The second
question that might generally come is what is CAPM and do you know any other method
that is used to calculate the cost of equity?