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Investment Banking Interview Guide, Basic DCF – Quiz Questions

Answers in bold.

Table of Contents:

• Walking Through and Explaining a DCF

• Calculating Free Cash Flow (FCF)
• Discount Rates and WACC
• Terminal Value
• Impact of Changes on a DCF and WACC

Walking Through and Explaining a DCF

1. Conceptually, a DCF analysis consists of a “near future” value (over 5-10

years) and a “far future” value (the company’s value past that period), both of
which are discounted back to their present values and summed up.
a. True
b. False
i. Explanation: The correct answer choice is A. The “near future”
value consists of the projected Free Cash Flows over the next 5
to 10 years, until the company reaches a steady state. The “far
future” value represents the Free Cash Flows generated in the
final year of the projection until perpetuity, and is
approximated by the Terminal Value, which can be calculated
using two differed approaches. Both values are discounted back
to present and added together to determine Enterprise (or
Equity) value, depending on which type of Free Cash Flows is
projected.

2. Which of the following steps do you complete in a DCF analysis?

a. Project cash flows in the “near future” period
b. Project cash flows in the “far future” period
c. Determine the appropriate discount rate to discount cash flows by

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d. Add together all the discounted cash flows to determine the NPV
i. Explanation: All of the above entail the steps necessary in
completing a DCF analysis. As mentioned before, the value of
the company consists of two components: ‘near future’ period
cash flows and ‘far future’ period cash flows. For the former we
can project these cash flows within a 5 to 10 year period. For the
latter, we need to approximate these cash flows by estimating
the Terminal Value. Once both ‘near future’ and ‘far future’ cash
flows are estimated, we calculate the appropriate discount rate
to determine their present values. Finally, once everything is
discounted to present value we add together the two figures to
obtain Enterprise (or Equity) value, depending on which type of
FCF we projected.

3. How is a Dividend Discount Model different from a conventional Discounted

Cash Flow analysis?
a. Dividends are discounted instead of Free Cash Flow
b. Cost of Equity is used as the discount rate instead of WACC
c. Terminal Value is based on a P / BV or P / E multiple instead of
EV/EBITDA
d. None of the above
i. Explanation: All of the statements above are correct differences
when doing a DDM instead of a DCF. Answer choice A is
correct as dividends are used in place of Free Cash Flow
(dividends are assumed to be a proxy for FCF for some types of
companies, such as banks and insurance firms). Answer choice
B is correct because in a DDM we only discount cash flows at
Cost of Equity, NOT the overall WACC – since dividends only
go to equity investors, we’re calculating Equity Value and using
Cost of Equity. Answer choice C is correct because we want to
use an Equity Value-based multiple, such as P / E or P / BV, as
opposed to an Enterprise Value-based multiple when using a
DDM.

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Calculating Free Cash Flow (FCF)

4. All of the following equations below are the correct definition of Unlevered
Free Cash Flow (Free Cash Flow to Firm) EXCEPT:
a. EBIT * (1 – Tax Rate) + Non-Cash Charges – Change in Operating
Assets and Liabilities – CapEx
b. CFO + Net Interest Expense * (1 – Tax Rate) – CapEx
c. Net Income + Net Interest Expense * (1 – Tax Rate) + Non-Cash
Charges – Change in Operating Assets and Liabilities – CapEx
d. Net Income + Non-Cash Charges – Change in Operating Assets and
Liabilities – CapEx – Mandatory Debt Repayments
e. None of the above (i.e. these are all correct)
i. Explanation: The correct answer choice is D. Unlevered Free
Cash Flow can be defined in more than one way, and answer
choices A, B, and C are all correct definitions of unlevered FCF.
Answer choice D, on the other hand, is NOT the definition of
Unlevered FCF but rather is the correct formula for Levered free
cash flow (since it includes interest payments and debt
repayment).

5. Which sections of the Cash Flow Statement do we generally exclude when

calculating Free Cash Flow?
a. Cash Flow from Operations (CFO)
b. Cash Flow from Investing (CFI), except for CapEx
c. Cash Flow from Financing (CFF)
d. None of the above – we need all these sections when calculating FCF
i. Explanation: When calculating Unlevered FCF we only take
CapEx from CFI and exclude everything else in that section as
well as CFF. The idea is that we are trying to only include
recurring, predictable items. And in the case of Levered FCF,
we still exclude almost everything from CFI and CFF sections
(with the exception of CapEx in FI and mandatory debt
repayments in CFF). Most other items in CFI and CFF are
usually one-time, non-recurring items (e.g. debt and equity

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issuances, sales of assets and securities) that in the majority of

cases do not represent recurring, predictable sources or uses of
cash for the company.

6. In a valuation context, using Unlevered FCF in a DCF gets you Enterprise

Value, whereas using Levered FCF gets you Equity Value.
a. True
b. False
i. Explanation: The correct answer choice is A. The statement
above is true. This is the case is because Unlevered FCF is
available to all investors in the firm (both debt and equity),
whereas Levered FCF included interest payments and
mandatory debt repayments, which means that the remaining
cash flows are available only to equity investors.

7. When trying to calculate Free Cash Flow (either Unlevered or Levered),

increases in operating assets – AR, inventory, etc. – represent a source of cash
(a cash inflow) while decreases in operating liabilities – AP, accrued
expenses, etc. – also represent a source of cash (a cash inflow).
a. True
b. False
i. Explanation: The correct answer choice is B. The statement
above is false. On the contrary, an increase in an operating asset
represents a use of cash, NOT a source of cash. On the other
hand, a decrease in operating liabilities represents a use of cash,
NOT a source of cash. Let’s say that Inventory increases. In
order for Inventory – an operating asset – to increase, cash must
have been used to purchase additional Inventory. The same
actually applies to any Operating Asset – an increase to an Asset
implies that you have spent cash to acquire that Asset. The
opposite is true for Liabilities – for example, if you raise Debt
you get extra cash as a result; if Deferred Revenue, Accounts
Payable, or Accrued Expenses go up, you also get extra cash

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because you collect additional cash up-front, or you’re waiting

longer to pay out cash.

8. All of the following are correct definitions of Levered Free Cash Flow (FCFE)
EXCEPT:
a. Net Income + Non-Cash Charges – Changes in Operating Assets and
Liabilities – CapEx – Mandatory Debt Repayments
b. (EBIT – Net Interest Expense) * (1 – Tax Rate) + Non-Cash Charges –
Changes in Operating Assets and Liabilities – CapEx – Mandatory
Debt Repayments
c. CFO – CapEx – Mandatory Debt Repayments
d. NOPAT + Non-Cash Charges – Changes in Operating Assets and
Liabilities – CapEx
i. Explanation: The correct answer choice is D. Answer choices A
thru C are all correct, albeit slightly different, formulae that
result in Levered Free Cash Flow (FCFE). Answer choice D is a
trick question in that it substituted ‘NOPAT’ – namely, Net
Operating Profits After Tax – in place of the usual “EBIT * (1 –
tax rate)”; these two phrases are synonymous. The key mistake
with answer choice D is that the formula provided is for
unlevered – as opposed to levered – free cash flow, because
NOPAT excludes interest income and expense, as well as
mandatory debt repayments.

9. When calculating Unlevered Free Cash Flow (Free Cash Flow to Firm), all of
the following are “Non-Cash Charges” that need to be added back to EBIT *
(1 – Tax Rate) EXCEPT:
a. Depreciation & Amortization (D&A)
b. Stock-Based Compensation (SBC)
c. Goodwill Impairment Charges
d. Non-Cash Restructuring Charges
e. All of the charges above should be added back
i. Explanation: All of these constitute non-cash charges. D&A and
SBC are the most common ones that you see with 99% of all

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companies, but Goodwill Impairment is another common non-

cash charge – it represents a write-down of Goodwill on the
Balance Sheet, but is not an actual cash loss. Many
Restructuring Charges are also classified as non-cash, and they
have the same impact as everything else here: they save the
company on taxes, but the actual expense does not cost the
company anything.

Discount Rates and WACC

10. WACC should always be used as the Discount Rate, regardless of the type of
Free Cash Flow you’re using in a DCF analysis.
a. True
b. False
i. Explanation: The correct answer choice is B. The weighted
average cost of capital – which includes both cost of equity and
cost of debt – should only be used when you’re using
Unlevered FCF as that cash flow is available to both debt and
equity investors. On the other hand, when calculating Levered
FCF one should use just the cost of equity (NOT WACC) to
discount such cash flows as they represent what is available
only to equity investors (i.e. they are after both interest expense
and debt repayments have been made).

11. Which of the formulas below correctly calculates WACC?

a. Cost of Equity * (% Equity) * (1 – Tax Rate) + Cost of Debt * (% Debt) *
(1 – Tax Rate) + Cost of Preferred Stock * (% Preferred)
b. Cost of Equity * (% Equity) * (1 – Tax Rate) + Cost of Debt * (% Debt) +
Cost of Preferred Stock * (% Preferred)
c. Cost of Debt * (% Debt) * (1 – Tax Rate) + Cost of Equity * (% Equity)
+ Cost of Preferred Stock * (% Preferred)
d. Cost of Debt * (% Debt) + Cost of Equity * (% Equity) + Cost of
Preferred Stock * (% Preferred)

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i. Explanation: The correct answer choice is C. Answer choice A is

incorrect because the Cost of Equity is NOT tax-affected since
dividends are not tax deductible in the same way that interest
expense on debt is. Answer choice B is incorrect because the (1 –
tax rate) should be on the cost of debt, not cost of equity.
Answer choice D is incorrect because the formula does not take
into account the tax-deductibility of debt financing. As you can
see from the answer choices, you never multiply the Cost of
Preferred Stock by (1 – Tax Rate) because just like dividends to
common shares, Preferred Dividends are also not tax-
deductible.

12. A company’s capital structure consists of 100% equity, with no Debt or

Preferred Stock outstanding. What is its WACC?
a. Cost of Equity
b. Impossible to say without knowing the company’s share price
c. Close to, but not exactly equal to Cost of Equity since future debt or
Preferred Stock issuances may affect it
d. It depends on the direction that interest rates are heading in the overall
economy
i. Explanation: Plug the numbers into the formula yourself and
see: when debt and Preferred Stock do not exist, WACC = Cost
of Equity because nothing else is there in the capital structure. B
is incorrect because share price has nothing to do with it; C is
incorrect because you only take into account future changes if
you know in advance what those changes will be. D is
completely wrong because future interest rates do not impact
WACC at all.

13. What does the “Cost of Equity” really mean? What does it actually “cost” a
company to issue equity to investors if there’s no interest expense or principal
repayment?
a. Dividend payments
b. After-tax dividend payments

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c. Giving up a percentage ownership in the company to 3rd party

investors
d. Giving up potential stock price appreciation to 3rd party investors
e. None of the above
i. Explanation: One explicit “Cost” of Equity is the dividend
payments that a company may be required to make after issuing
equity, if its policy is to issue dividends. Note that unlike
interest expense, dividend payments are NOT tax deductible,
and as a result answer choice B is incorrect. Aside from explicit
dividends, issuing equity also has the opportunity cost of giving
up future stock price appreciation to others rather than keeping
it for the company itself. As a result, both A and D are correct
answer choices. C is incorrect because giving up percentage
ownership in the company is not a true “cost” in the same way
as the opportunity cost of giving up stock price appreciation. It
just means that existing shareholders will have less say in the
company’s affairs.

14. Which of the following inputs is NOT required to calculate Cost of Equity for
a company in the conventional way (i.e. by using the Capital Asset Pricing
Model)?
a. Expected yield on a 20-year US (or other government) Treasury Bond
b. Beta of the company’s stock (historical or estimated)
c. The difference between expected returns in the relevant stock market
index (e.g. the S&P 500 or the FTSE 100 in Europe) and a “risk-free”
Treasury Bond
d. None of the above – you need all of them to calculate Cost of Equity
i. Explanation: According to CAPM, Cost of Equity = Risk-free
rate + Equity Risk Premium * Beta. Answer choice A is a proxy
for the risk-free rate part of the formula (note: it doesn’t have to
be a 20 year Treasury...it could easily be a 10 year Treasury or
something else – this tends to be bank specific and group
specific). You also need Beta to measure the riskiness and
expected returns of the stock relative to the rest of the market,

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and you need C (the Equity Risk Premium) to determine how

much, on average, companies may return over risk-free
securities (which you then adjust using Beta).

15. When calculating the Cost of Equity, we always need to go through the
process of un-levering Beta for each comparable company, finding the
median, and then re-levering based on the company’s own capital structure.
a. True
b. False
i. Explanation: There is no absolute requirement that you have to
do this, but it is the most common method for estimating Beta in
the Cost of Equity formula. The logic is that you get “more
accurate” numbers by factoring in the median “inherent
business risk” of all the comparable companies than you do by
only looking the riskiness of the company you’re valuing.
However, you could just use the historical Beta of the
company you’re valuing. It’s not necessarily “wrong,” and the
two numbers are often very close, especially in highly
fragmented markets with lots of similar competitors.

16. Which of the following formulas represent CORRECT methods for

calculating Cost of Equity?
a. Risk-Free Rate + Equity Risk Premium * Beta
b. (Earnings per Share / Share Price) + Growth Rate of EPS
c. (Dividends per Share / Share Price) + Growth Rate of Dividends
d. Calculate the Capitalized Annual Growth Rate (CAGR) of the
company’s annual return, including dividends, over the past 5-10
years
i. Explanation: Answer choice A is correct as that is the
traditional ‘Capital Asset Pricing Model’ (aka CAPM)
formula used for Cost of Equity. Answer choice B is
incorrect, as the alternative method of calculating Cost of
Equity does not deal with EPS figures or growth rates. The
other correct answer choice here is C. Note the first part of

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the formula – Dividends per Share / Share Price – is also

referred to as ‘dividend yield’. This should make sense as
the “expense” of issuing stock is the dividend it pays (as a
percentage of share price) plus the expected growth rate in
that dividend payment. While D is an interesting idea, in
practice you never use such a formula or technique to
calculate Cost of Equity.

17. When you discount Unlevered Free Cash Flows, you use Unlevered Beta in
the Cost of Equity calculation, but when you discount Levered Free Cash
Flows you use Levered Beta.
a. True
b. False
i. Explanation: This is a trick question intended to confuse you
and test whether you really understand the concepts. To
discount Unlevered FCF, you use WACC and to discount
Levered FCF you use Cost of Equity… but the Cost of Equity
calculation itself never changes regardless of which Discount
Rate you use. The reason it never changes is that Debt and
Equity both make an impact on the overall riskiness of a
company regardless of whether you’re looking at Unlevered or
Levered FCF. So effectively you always have to use Levered
Beta when calculating Cost of Equity – Unlevered Beta is just a
by-product of an intermediate step in the process.

18. Company A is in a non-cyclical industry and is financed with 100% equity.

Company B is in a highly cyclical industry and is financed with 40% debt and
60% equity in its capital structure. Which company would you expect to have
a higher Beta, Company A or Company B?
a. Company A
b. Company B
c. Both should have about the same Beta, because the extra risk
introduced by 100% equity will be canceled out by the fact that
Company A is in a non-cyclical industry

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d. You need additional information to answer the question

i. Explanation: Cyclicality will always increase Beta because it
makes the stock’s performance vary more than the performance
of the market as a whole. Debt will also always increase Beta
because a company with Debt is riskier than one without Debt
due to the possibility of defaulting. So Company B should have
a higher Beta. The statement in answer choice C sounds
tempting, but it is untrue because a 100% equity capital
structure does not introduce “extra risk.” And D is false because
you already have enough information to make an educated
guess.

19. Consider the values for Beta listed below. With which value would a stock
move in the OPPOSITE direction from the overall market?
a. Beta = 1.0
b. Beta = 0.5
c. Beta = -1.0
d. Beta = 2.0
e. Beta = 0.0
i. Explanation: The correct answer choice is C. The Beta of the
market as a whole is assumed to be 1.0, so answer choice A
would move directly in proportion to the overall market. A Beta
of less than 1.0 would indicate the stock is less volatile than the
market as a whole; however, the stock would still move in the
same direction as the overall market. The same applies for B
and D, only they move less or more in that same direction.
Answer E corresponds to a stock that is completely independent
of the overall market. Only a stock with a negative Beta would
move in the OPPOSITE direction as the overall market, thereby
making answer choice C the correct answer. Negative Betas are
theoretically possible, but are extremely rare to nonexistent for
normal stocks and you usually only see them for other types of
assets such as certain commodities.

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20. ACME Co. had a Cost of Equity of 11% before a prolonged recession began. If
all else remains equal and the company’s financial performance continues as
expected, what might its Cost of Equity change to once the recession starts?
a. 13%
b. 9%
c. 11% – No changes
d. Impossible to say without knowing its capital structure
i. Explanation: Think about the individual components here: Cost
of Equity = Risk-Free Rate + Equity Risk Premium * Beta. It is
reasonable to assume that the risk-free rate (as measured by the
rate on a long dated Treasury bond) would drop once the
economy enters into a recession. However, the other two
components of Cost of Equity would almost certainly increase
more than enough to offset the drop in risk-free rate – because
in a recession, stocks fluctuate far more and investors become
willing to pay a premium for superior performance and returns.
There’s another way to think about this as well: in a recession,
all else being equal, does a company’s Equity Value increase or
decrease? Since 99% of companies’ stock prices decline,
resulting in lower Equity Values, that implies that the Cost of
Equity has increased since that’s what you use when
discounting cash flows in a Levered DCF to arrive at Equity
Value. D is incorrect because Debt and Preferred Stock do not
affect Cost of Equity, only WACC.

Terminal Value

21. You are valuing ACME Co., a highly cyclical basic materials manufacturer.
You have calculated the Unlevered Free Cash Flows for the next five years.
Now you need to calculate the Terminal Value. Currently the sector is in an
“expansion” phase where valuations tend to be higher, but in 6 years you
expect the market to reverse and enter the “contraction” phase of the cycle.
Which method should you use to calculate ACME Co.’s Terminal Value?
a. Terminal Multiple Method

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b. Gordon Growth Method

c. Either method would produce the same results
d. You need to see the median multiples the comps are trading at first
i. Explanation: In practice, most bankers use the Exit Multiple
method to calculate Terminal Value. However, ACME Co. is in
a highly cyclical sector (i.e. basic materials) and the question
states that beyond year 5 of cash flows projected, the cycle
affecting basic materials is expect to completely reverse itself. In
this case, it would not make sense to apply an exit multiple
because it would be based on current market conditions, which
would not hold up once Year 6 comes around. So in this case, it
is better to base the company’s value on its expected FCF
growth far into the future (Gordon Growth) than on the current
market multiples.

22. You are calculating the Terminal Value of a high-growth technology

company in a DCF, and the company has $0 in Operating Income (EBIT) from
Year 1 to Year 5. How do you calculate Terminal Value?
a. Terminal Multiple Method: Enterprise Value / EBIT
b. Terminal Multiple Method: Enterprise Value / Revenue
c. Terminal Multiple Method: Equity Value / Net Income
d. Gordon Growth Method: Estimate long-term FCF growth
e. Terminal Multiple Method: Enterprise Value / Unlevered FCF
f. Question is misleading – you should not be using a DCF at all for
this scenario
i. Explanation: A DCF only makes sense if the company is
profitable and has relatively stable, predictable cash flows. A
DCF is least applicable to a high-growth company with minimal
profits, and in a scenario like this it is relatively useless for
valuation purposes. If you projected it out 10-20 years into the
future and the company actually had positive EBIT or cash flow
by them, it might make more sense to use Terminal Value and
stick with the DCF analysis. But otherwise, none of these

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answers is correct because the premise of the question is flawed

in the first place.

23. ACME Co. is based in the US or another developed country with a long-term
GDP growth rate of 2-3%. Historically, ACME Co. has grown its Free Cash
Flow year-over-year by over 10%. You have projected the Free Cash Flows for
the next 5 years and are using the Gordon Growth method to calculate its
Terminal Value. ACME Co. has consistently outperformed its peers and is
ahead of every other company in the industry by a longshot. What would be
a reasonable assumption for the long-term growth rate you use when
calculating Terminal Value in the DCF?
a. 2-3%
b. 9-10%
c. 5-7%
d. Unable to determine this without looking at FCF growth from peer
companies
i. Explanation: Regardless of how quickly the company has
grown historically, you should never use a long-term growth
rate far in excess of the country’s GDP growth rate or the rate of
inflation. Think about the math for a second there: if you
assume that the company grows faster than the economy as a
whole far into the future, eventually the company itself will be
bigger than the economy of the entire country, which is
impossible. So 9-10% is far too high, and even 5-7% is too high.
2-3% is more reasonable because that is in-line with the
country’s GDP growth rate. D is incorrect because we know that
the company has outperformed its peers, so getting their FCF
growth rates would not make a big difference here.

24. When using the Terminal Multiple method to determine Terminal Value,
how should you determine the appropriate range of multiples to use in the
analysis?
a. Base it on the range of multiples for the Public Comps
b. Base it on the range of multiples for the Precedent Transactions

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c. Base it on the range of multiples for the Public Comps, but use
slightly lower multiples to account for the fact that multiples decline
over time
d. You should come up with reasonable long-term growth rate
assumptions first, use the Gordon Growth Method, and then work
backwards to come up with the equivalent multiples.
i. Explanation: B is incorrect because multiples tend to be higher-
than-normal for Precedent Transactions since buyers must pay a
control premium when acquiring sellers, and in a DCF analysis
we want to be as conservative as possible. A is the right idea,
but we want to be even more conservative than that to account
for the fact that valuation multiples will decline into the future
as companies grow and earn higher revenue and EBITDA, so C
is the best option here. D is not “wrong,” but you would use the
method in D if you already have the Terminal Value via the
Gordon Growth method and you want to double-check your
work by seeing what the implied valuation multiples are.

25. The Gordon Growth method for calculating Terminal Value can always be
used as a substitute to the Terminal Multiple method in all situations.
a. True
b. False
i. Explanation: The correct answer choice is B. Most of the time,
either method can be used and in practice you can move from
one to the other by working backwards. However, given the
way the mathematics of the Gordon Growth Model (GGM) are
set up, if the Discount Rate happens to be lower than the
terminal period growth rate, the GGM will produce a negative
value for Terminal Value (as the denominator would result in a
negative number), thereby making the value meaningless.
Another scenario that can render the GGM less meaningful is
when the difference between the Discount Rate and the
perpetuity growth rate is big; in this scenario, you would get
outsized Terminal Values. Finally, if you lack sufficient

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information to determine long-term growth rates, then the

GGM may not be as applicable when calculating Terminal
Value.

26. Which of the following statements is TRUE regarding the ‘intuition’ behind
Terminal Value when calculated using the Gordon Growth method?
a. It represents the present value of Free Cash Flows generated into
perpetuity
b. It represents the ‘capitalized’ value of ongoing Free Cash Flow
generation at a constant growth rate into infinity
c. Given a constant cash payment received and required return rate on
our part, it represents the amount we can “afford” to pay up front now
for future steam of cash (e.g. we can pay $100 now if we’re aiming for a
10% return over 5 years from a set of cash flows)
d. All of the above
e. None of the above
i. Explanation: The correct answer choice is D. All of the above
statements are true reflections of the ‘intuition’ behind the
Gordon Growth Method (GGM) of calculating Terminal Value
(TV). Basically the GGM is a mathematical simplification to a
complex problem of having to project Free Cash Flows beyond
our 5-year projection period. As described in the DCF Guide,
these Free Cash Flows into perpetuity represent a ‘geometric
series’ in which we can determine the value of that entire stream
of FCF in the ‘far future’ period by applying the GGM formula.
The GGM formula is Yr. 5 FCF * (1 + Growth Rate) / (Discount
Rate – Growth Rate). Mathematically, what this formula is
doing is taking the final period FCF projected and growing it by
the steady state growth rate. It then takes that figure and
‘capitalizes’ it by dividing by the appropriate discount rate less
that same steady state growth rate. The concept is difficult to
grasp at first but it is basically a mathematical ‘short-cut’
solution to the messy problem of projecting FCF from year 5 to
infinity. If you look at the questions and answers included in

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the interview guide, we address the intuition there and give an

example of how it works. The easiest way to think of it is
answer choice C – given a required return rate and a stream of
cash flows, what could we pay to achieve that return?

27. You’ve calculated the present value of Terminal Value and the present value
of Free Cash Flows in a DCF. Which of the following values would be LEAST
likely for the Present Value of Terminal Value as a percentage of Enterprise
Value?
a. 10%
b. 75%
c. 50%
d. 90%
i. Explanation: Most often in a DCF analysis, the present value of
the Terminal Value comprises a huge percentage of the
company’s implied Enterprise Value. Percentages of up to 75%
and even beyond that, up to 90%, are not unusual. In fact,
sometimes bankers go back and modify assumptions if the
value there is too high. 10% would be very unusual and the least
likely outcome here, because effectively it’s saying that 90% of a
company’s value comes from the next 5 years, but only 10% of
its value comes from Year 6 into infinity – which doesn’t make
intuitive sense. This percentage is almost always at least 50%,
and sometimes much higher than that.

28. When calculating Terminal Value, how can you check your calculations and
ensure that the number you’ve calculated is not completely wrong?
a. Use both the Terminal Multiple method and Gordon Growth method
and compare the numbers
b. Work backwards to determine the implied Long-Term growth rate,
based on the Terminal Value calculated with the Multiples method
c. Work backwards to determine implied Terminal EBITDA multiple,
based on the Terminal Value calculated with the Gordon Growth
method

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d. All of the above

i. Explanation: The correct answer choice is D. The Terminal
Value (TV) constitutes the majority of value in a DCF analysis.
Therefore, it is important to ensure that this TV value is correct.
In practice, bankers usually use the Terminal Multiple method
to determine TV. However, both methods can be used so as to
crosscheck the value produced by either method. It is usually a
good idea to use both methods, and then to work backwards to
determine what the ‘implied Long-term growth rate’ is using
the Terminal Multiple method, and what the ‘implied EBITDA
multiple’ would be using the Gordon Growth method. The
reason this is used as a sanity check is because if you use the
Terminal Multiple method to calculate TV, and then work
backwards and determine the implied Long-Term Growth Rate
is 12%, then this is a clear indication that the EBITDA multiple
used is incorrect – a company growing at 12% forever would
eventually surpass the size of the world’s economy.

Impact of Changes on a DCF and WACC

29. Assume ACME Co. has a 10% revenue growth rate over a 5-year period, and
a WACC of 10%. Which will have a bigger impact in a DCF: reducing the
revenue growth rate to 9% or reducing WACC to 9%?
a. Reducing revenue growth by 1%, to 9% rather than 10%
b. Reducing WACC by 1%, to 9% rather than 10%
c. Both will have same effect
d. It’s impossible to guess without additional information
i. Explanation: The correct answer choice is B. The key concept
here is that even small changes in the discount rate will have an
enormous impact on the model, much more so than small
changes in revenue growth. In terms of valuation, a reduced
WACC has a much greater effect on total value than a 100 basis
point drop in revenue growth rate, because the latter will affect
our Free Cash Flow calculations slightly, whereas the lower

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WACC discount rate is applied to all the Free Cash Flows in

both the ‘near future’ and ‘far future,’ and therefore has a much
greater impact on the Terminal Value, which usually comprises
the majority of value in a DCF.

30. Assume ACME Co. has a revenue growth rate of 10% over a 5-year period
and a Cost of Equity of 10%. Which will have a greater impact on Equity
Value: reducing the revenue growth rate TO 1% or reducing the Cost of
Equity TO 9%?
a. Reducing the revenue growth rate TO 1%
b. Reducing the Cost of Equity TO 9%
c. It depends on the company in question
d. You can’t determine the impact with Cost of Equity, only with WACC
i. Explanation: The correct answer choice is A. In this case, we are
reducing the revenue growth rate by 90% versus only lowering
the Cost of Equity (aka ‘discount rate’) by 10%. In this scenario
the final Equity Value would most likely be impacted more by
the revenue growth rate reduction because that lower revenue
growth rate affects Free Cash Flows over the near future period
as well as the Terminal Value. Normally, the discount rate tends
to have a bigger impact, but when you’re looking at a 90%
change in revenue growth vs. a 10% change in the discount rate,
the revenue growth rate change will almost always have a
bigger impact. It would be much tougher to assess if it were,
say, a 40% change in revenue growth vs. a 20% change in the
discount rate, and in that case it really could go either way. D is
incorrect because it’s clear that we’re using a Levered FCF
analysis here due to the “Equity Value” reference, so WACC
isn’t even relevant.

31. Assume ACME Co. is financed 100% with equity and decides to change its
capital structure to 90% equity and 10% debt. What would happen to its
overall WACC?
a. WACC would decrease

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b. WACC would increase

c. WACC would remain the same
d. None of the above
i. Explanation: The correct answer choice is A. Note that we are
not given its Cost of Equity or WACC – but we don’t actually
need numbers for those figures. The general idea is that when a
company is completely financed with equity and decided to
issue a small amount of debt, the WACC in most cases will
decrease because the Cost of Debt is almost always lower than
the Cost of Equity, thus driving the WACC down. Two things to
keep in mind are that we use the after-tax cost of Debt (as
interest expense is tax deductible) which is lower than the Cost
of Equity in 99.9% of cases, and also that Debt interest rates by
themselves (usually under 10%) tend to be lower than the Cost
of Equity (often over 10%) to begin with.

32. Assume ACME Co. is financed 100% with equity and decides to recapitalize
itself to have 25% debt and 75% equity in its capital structure. What would
happen to the Cost of Equity?
a. Cost of Equity would decrease
b. Cost of Equity would increase
c. Cost of Equity would stay the same since it’s not dependent on the
capital structure or the amount of debt the company has
d. Need more information to determine the answer
i. Explanation: The correct answer choice is B. Think about the
formula for Cost of Equity: Risk-Free Rate + Equity Risk
Premium * Levered Beta. The Risk-Free Rate and Equity Risk
Premium would not change here. However, Levered Beta
would increase if the company raises additional Debt because
its overall risk is higher. And yes, the normal equity investors
(shareholders) are still impacted by Debt because it increases
risk for them as well: the company has a higher chance of going
bankrupt, for example. So C is incorrect because Cost of Equity
IS, in fact, impacted by capital structure. A is incorrect because

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additional Debt would always increase Levered Beta, which

pushes Cost of Equity up. D is incorrect because additional
Debt, all else being equal, always increases Cost of Equity.

33. Company A and B generate the same total Free Cash Flow over 5 years. But
Company A generates 90% of its FCFs in the initial 2 years, whereas
Company B generates 20% in each year. Assuming the same discount rate,
which company’s FCFs have a higher NPV?
a. Company A
b. Company B
c. Both have the same NPV
d. It depends on the discount rate – you can’t tell with the information
given
i. Explanation: The correct answer choice is A. The concept here is
that Free Cash Flows generated earlier are worth more than the
same amount generated in later periods. This comes back to the
time value of money: money today is worth more than money
tomorrow because you could re-invest money today and earn
interest on it. In a DCF context, if both companies have identical
cash flows but one produces higher cash flows upfront, the
NPV of those cash flows will be higher because cash flows in
earlier periods have less of a discount applied. D is incorrect
because the discount rate is irrelevant as long as you’re using
the same rate for both companies – this is about the concept of
the time-value of money, not the specific numbers.

34. Now let’s extend this same scenario. Which company would MOST likely
have the higher Terminal Value in a DCF analysis under the same conditions?
a. Company A
b. Company B
c. Can’t tell without additional information
d. Both would have the same Terminal Value since the total FCFs for each
one are the same

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i. Explanation: B is correct because its Free Cash Flow will be

significantly higher than A’s FCF in Year 5, if Company A
generates less than 10% of its total FCF in that final year. So this
is the other side to a scenario like this: yes, the NPV of Free
Cash Flows is higher if they arrive earlier on in higher numbers,
but the Terminal Value is likely to be much lower if they
decline in future years. And, in turn, that means that Company
B is likely to be worth a lot more than Company A in this
analysis since the Terminal Value comprises the majority of
value in most DCF analyses. C is incorrect because we have all
the information we need, and D is incorrect because Terminal
Value is dependent on the final year FCF, not the total FCFs
generated in the 5-year projection period.

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