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Analyst Interview Group

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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.

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