Analyst Interview Group

How does the application of the Discounted Cash Flow (DCF) model differ for a company with no debt compared to a company with a significant amount of debt, and what specific considerations should be taken into account when valuing an unleveraged company using the DCF approach?

Key Differences and Considerations:

Discount Rate:

• No Debt: The discount rate is the cost of equity, calculated using the Capital Asset Pricing Model (CAPM). It doesn't account for debt.

• With Debt: The discount rate is the weighted average cost of capital (WACC), combining the cost of equity and the after-tax cost of debt. Beta (β):

• No Debt: Use unleveraged beta, reflecting the company's market risk without debt.

• With Debt: Use leveraged beta, which includes financial risk from debt. Tax Shield:

• No Debt: No tax shield benefit since there are no interest payments to deduct.

• With Debt: Includes tax shield from deductible interest, lowering the discount rate. Financial Risk:

• No Debt: Lower financial risk, leading to a lower cost of equity.

• With Debt: Higher financial risk, resulting in a higher cost of equity.

Specific Considerations for an Unleveraged Company:

1. Accurate Cost of Equity: Ensure accurate CAPM calculation using a risk-free rate, market risk premium, and unleveraged beta.

2. Consistent Cash Flows: Project cash flows without the impact of debt.

3. Growth Assumptions: Justify growth rates, as they significantly affect terminal value.

4. Sensitivity Analysis: Test how changes in key assumptions impact valuation.

By focusing on these aspects, the DCF model can effectively value an unleveraged company.