# Investment banking DCF - basic

Walk me through a DCF.
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"A DCF values a company based on the Present Value of its Cash Flows and the Present Value of its Terminal Value.
First, you project out a company's financials using assumptions for revenue growth, expenses and Working Capital; then you get down to Free Cash Flow for each year,
which you then sum up and discount to a Net Present Value, based on your discount rate - usually the Weighted Average Cost of Capital.

Once you have the present value of the Cash Flows, you determine the company's Terminal Value, using either the Multiples Method or the Gordon Growth Method, and
then also discount that back to its Net Present Value using WACC.

Finally, you add the two together to determine the company's Enterprise Value."
Subtract COGS and Operating Expenses to get to Operating Income (EBIT). Then,
multiply by (1 - Tax Rate), add back Depreciation and other non-cash charges, and subtract Capital Expenditures and the change in Working Capital.

FCF = EBIT (1-rate)+DA-CAPX-change in working capital

Note: This gets you to Unlevered Free Cash Flow since you went off EBIT rather than EBT. You might want to confirm that this is what the interviewer is asking for.
The formula is:
Cost of Equity (% Equity) + Cost of Debt (% Debt) * (1 - Tax Rate) +
Cost of Preferred * (% Preferred).

In all cases, the percentages refer to how much of the company's capital structure is taken up by each component.
For Cost of Equity, you can use the Capital Asset Pricing Model (CAPM - see the next question) and for the others you usually look at comparable companies/debt issuances and the interest rates and yields issued by similar companies to get estimates.
Cost of Equity = Risk-Free Rate + Beta * Equity Risk Premium
E[r] = rf + B[rm-rf]

The risk-free rate represents how much a 10-year or 20-year US Treasury should yield;
Beta is calculated based on the "riskiness" of Comparable Companies and the Equity Risk Premium is the % by which stocks are expected to out-perform "risk-less" assets. Normally you pull the Equity Risk Premium from a publication called Ibbotson's.

Note: This formula does not tell the whole story. Depending on the bank and how precise you want to be, you could also add in a "size premium" and "industry premium" to account for how much a company is expected to out-perform its peers is
according to its market cap or industry.
Small-company stocks are expected to out-perform large company stocks and certain industries are expected to out-perform others, and these premiums reflect these expectations.
You look up the Beta for each Comparable Company (usually on Bloomberg), un-lever each one, take the median of the set and then lever it based on your company's capital
structure. Then you use this Levered Beta in the Cost of Equity calculation.
For your reference, the formulas for un-levering and re-levering Beta are below:

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)))
Again, keep in mind our "apples-to-apples" theme. When you look up the Betas on Bloomberg (or from whatever source you're using) they will be levered to reflect the
debt already assumed by each company.
But each company's capital structure is different and we want to look at how "risky" a company is regardless of what % debt or equity it has.

To get that, we need to un-lever Beta each time.
But at the end of the calculation, we need to re-lever it because we want the Beta used in the Cost of Equity calculation to reflect the true risk of our company, taking into account its capital structure this time.