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DCF M&I

Terms in this set (71)

First, you project the company's revenue growth, i.e. the percentage it grows revenue by each year over that 5-10 year "near future" period. From that, you can determine the company's projected annual revenue based on the most recent historical numbers.
Next, you need to assume an operating margin for the company so that you can calculate its EBIT, or Operating Income, each year. Usually you base this on historical margins. So if they have $1 billion in revenue and a 30% EBIT Margin, that's $300 million in EBIT.
Now, you apply the company's effective tax rate to calculate its Net Operating Profit After Tax, or NOPAT. Continuing with this example, if the tax rate is 40% then the NOPAT is $300 million * (1 - 40%), or $180 million.

Once you have this, you move to the Cash Flow Statement and project the 3 key items there that impact Free Cash Flow: Non-Cash Charges, Changes in Operating Assets and Liabilities, and Capital Expenditures.5)The main Non-Cash Charges are Depreciation & Amortization; you may also project others, such as Stock-Based Compensation. You add them back here because you want to reflect how the company saves on taxes, but does not actually pay any cash for them. You can make these percentages of revenue. If we assumed they were equal to 5% of revenue here, we'd add back $50 million here.

Next, you estimate the change in Operating Assets and Liabilities. What this really means is, "If the company's Operating Assets increase more than its Operating Liabilities, it needs extra cash to fund that... so it reducescash flow. If its Liabilities increase more, that adds to cash flow." You can make this a percentage of revenue as well - so if it's 3% of revenue and Assets increase more than Liabilities, then we subtract $30 million here.

Finally, you estimate Capital Expenditures each year, which always reduces cash flow. You might average previous years' numbers, assume a constant change, or make it a percentage of revenue. In this case if CapEx is $50 million, that reduces cash flow by $50 million.

So what's the Free Cash Flow in this case? You take NOPAT, $180 million, add back the $50 million of non-cash charges, subtract the $30 million change in Operating Assets and Liabilities, and subtract the $50 million of CapEx, so that FCF equals $150 million.
Break it down and think of the individual components of WACC: Cost of Equity, Cost of Debt, Cost of Preferred, and the percentages for each one.Then, think about the individual components of Cost of Equity: the Risk-Free Rate, the Equity Risk Premium, and Beta.•The Risk-Free Rate would decreasebecause governments worldwide would drop interest rates to encourage spending.•But then the Equity Risk Premium would also increase by a good amount as investors demand higher returns before investing in stocks.•Beta would also increase due to all the volatility.•So overall, we can guess that the Cost of Equity would increase because the latter two increases would likely more than make up for the decrease in the Risk-Free Rate.Now, for WACC:•The Cost of Debt and Cost of Preferred Stock would both increase as it would become more difficult for companies to borrow money.
The Debt to Equity ratio would likely increase because companies' share prices would fall, meaning that Equity Value decreased for most companies while Debt stayed the same...•So proportionally, yes, Debt and Preferred would likely make up a higher percentage of a company's capital structure.•But remember: the Cost of Debt and Cost of Preferred both increase, so that shift doesn't matter too much.•As a result, WACC almost certainly increases because almost all these variables push it up - the only one that pushes it down is the reduced Risk-Free Rate.There's a simpler way to think about it as well: all else being equal, did companies become more valuable or less valuable during the financial crisis?Less valuable - because the market discounted their future cash flows at higher rates. So WACC must have increased.