This is the one question that all interviewees can expect to get in an investment banking interview (and possibly a coffee chat), so there is no excuse to not be prepared for this question coming up – it’s about the same as forgetting to put on a suit.
My sentiment is that if you get this question and you stumble, you’re out of the process. Professionals who take the time to conduct and interview will feel candidates are wasting their time if they are unable to prepare for the most basic questions, so messing up the answer can actually place you on a blacklist.
Most applicants can answer walk me through a DCF (Discounted Cash Flow), but they cannot answer it well because they try to spit out everything they know at the same time which leads to a lengthy and poor communicated answer. The correct way to answer the question is to be succinct – I know of bankers who actually time the candidates in terms of how quickly they can answer the question. We run through some iteration of this in our technical interview guide, but we are providing an extended example here.
So this is how you should do it:
Walk me through a DCF.
- Calculate free cash flow for a forecast horizon of 5-10 years
- Determine a terminal value for cash flows after they stabilize after the forecast period
- Discount these cash flows at an appropriate risk-adjusted rate
That is the correct answer and the interviewer can probe from there. And everyone should use this answer – it doesn’t matter if it’s the same answer as everyone else because this is structured for the interviewer to see how you get to each value described – and suddenly all candidates are able to showcase their knowledge in a concise manner.
That is, assuming the candidate can be as crisp for all the questions that come after.
The logical follow up is:
How do you get to free cash flow?
We are assuming free cash flow to the firm or unlevered free cash flow. You start at net income, add back interest expense (less interest tax shield) as on an unlevered basis this would be available to the firm, add non-cash charges (such as depreciation), subtract capital expenditures and subtract the change in net working capital.
If you want levered free cash flow, you take away the tax-adjusted interest, and subtract net debt repayments.
To make sure you fully understand accounting identities, they may ask how you to get there from EBITDA or EBIT.
How do you calculate your terminal value?
One way is to treat the free cash flows as a perpetuity, assuming the business is ongoing. You take the last forecasted free cash flow number and multiply that by 1 plus a terminal growth rate (has to be reasonable, usually at the same rate as GDP). The denominator will be the discount rate less the growth rate.
OK, and how do you get to this discount rate?
For an unlevered firm, the appropriate discount rate to use is the WACC, or weighted average cost of capital. Capital can include debt, equity and preferred shares.
The appropriate rate for the debt is the after-tax blended interest rate (one could argue it is the current cost, which you would need the current bond pricing for – but that is too complicated for this example). It is after-tax because interest is tax deductible.
The appropriate rate for the preferred shares is the preferred coupon. This is not tax deductible.
The return on equity for the firm is based on the Capital Asset Pricing Model, or CAPM (pronounced “Cap-M”).
OK, hold on a second, what is the CAPM?
The CAPM is a model which calculates the expected return on an asset based on its sensitivity to systematic (or undiversifiable) risk. The appropriate formula for the return on equity would be:
Risk-free rate (10-year government bond) + equity beta (expected return on stock market – risk-free rate)
That’s fine. Let’s say the company isn’t publicly traded but we have a good pure play peer group here with an equity beta of 1.2 and debt/capitalization of 33.3%. The company we are looking at has a debt/capitalization of 50%.
You will have to un-lever and re-lever the beta to the appropriate capital structure. The formula for un-levering beta is:
Asset Beta = Equity Beta/(1+debt/equity*(1-t))
Asset Beta = 1.2/(1+1/2*(.75))
Asset Beta = 0.87
Note: Two tricky steps here – 1) although debt to capitalization is .33 the formula for unlevering beta uses debt/equity – which means that equity was at .66 and D/E is .33/.66 – many candidates mess this up; 2) If the interviewer does not provide a tax rate, the US corporate tax rate is ~40% while the Canadian is ~25%. Walk them through why you chose this tax rate. You could also use a blended rate for Canadian companies with US operations – US domiciled companies have to pay the difference back to the US so it will always be 40%.
Company Beta = Asset Beta x (1+D/E(1-T))
Company Beta = Asset Beta x (1+1(.75)) = 1.52
Hopefully there aren’t any questions after that.