Discounted Cash Flow

Free cash flow (FCF), as used in a DCF valuation, is most accurately described as:

1. A.Net income reported on the income statementWrong. Net income includes non-cash charges and does not reflect capital expenditure needs the way FCF does.
2. B.Cash generated from operations after deducting the capital expenditures needed to sustain and grow the businessCorrect. This is the standard definition of free cash flow used in a DCF.
3. C.Total revenue less cost of goods soldWrong. That describes gross profit, not free cash flow.
4. D.The cash balance shown on the balance sheet at year-endWrong. A cash balance is a stock (point-in-time) figure, not a flow of cash generated during the period.

Why: Free cash flow represents the cash a business generates from operations after accounting for the capital expenditures needed to sustain and grow the business — the cash actually available to all capital providers.

A single projected cash flow of $121 million is expected in exactly two years. Using a discount rate of 10%, what is its present value?

1. A.$146.4 millionWrong. This multiplies by (1.10)^2 instead of dividing by it.
2. B.$100 millionCorrect. $121M ÷ 1.21 = $100 million.
3. C.$110 millionWrong. This only discounts for one year instead of two.
4. D.$121 millionWrong. This is the undiscounted future value, not its present value.

Why: PV = FV ÷ (1 + r)^n = $121M ÷ (1.10)^2 = $121M ÷ 1.21 = $100 million.

True or False: Holding all projected cash flows constant, increasing the discount rate (WACC) used in a DCF will decrease the resulting present value.

1. A.TrueCorrect. A higher discount rate reduces the present value of a given stream of future cash flows.
2. B.FalseWrong. Present value and discount rate move in opposite directions, holding cash flows constant.

Why: Present value is inversely related to the discount rate — a higher discount rate divides future cash flows by a larger factor, reducing their present value, all else equal.

A buy-side deal team produces preliminary stand-alone and pro forma valuations of the target using comparable company analysis, precedent transaction analysis and a DCF, rather than relying on just one method. What is the primary reason for using multiple methods rather than a single one?

1. A.Each method measures a different valuation perspective, and together they produce a defensible range rather than a single potentially misleading numberCorrect. This is the core rationale for using multiple valuation methods together.
2. B.FINRA rules require at least three valuation methods for every acquisitionWrong. There is no such FINRA numeric-method requirement; using multiple methods is standard practice, not a specific rule mandate.
3. C.Multiple methods are used only to double-check for arithmetic errors in a single calculationWrong. The methods are conceptually distinct, not simply redundant checks on the same math.
4. D.Only the DCF result is actually used; the other methods are performed for appearance onlyWrong. All the methods genuinely inform the valuation range and judgment, not just DCF alone.

Why: Each valuation method captures a different perspective — comps reflect current market sentiment, precedent transactions reflect control-premium deal pricing, and DCF reflects intrinsic value from projected fundamentals. Using several together produces a defensible valuation range and surfaces where the methods agree or diverge, rather than anchoring on a single, potentially misleading number.