The discounted cash flow is the single most tested model in finance interviews. These questions work through each component, from free cash flow to WACC to terminal value, with answers you can check yourself against.
Try to answer each one aloud before reading the solution, the way an interviewer would ask it.
1. Project unlevered free cash flow over an explicit forecast, usually five to ten years. 2. Calculate WACC as the blended required return of debt and equity. 3. Discount each year's cash flow back to today at WACC. 4. Calculate a terminal value for the period beyond the forecast and discount that back as well. 5. Sum the discounted cash flows and discounted terminal value to reach enterprise value. 6. Bridge from enterprise value to equity value by subtracting net debt, then divide by diluted shares.
Start at EBIT, then multiply by (1 minus the tax rate) to get net operating profit after tax. Add back D&A because it is non-cash. Subtract capex and subtract the increase in net working capital. The result is the cash available to all capital providers before any financing decision. It is called unlevered precisely because interest never appears: the cost of debt is captured in the discount rate instead, not in the cash flow.
WACC equals (E/V) x cost of equity plus (D/V) x cost of debt x (1 minus tax), where E and D are the market values of equity and debt and V is their sum. Cost of equity comes from CAPM. Cost of debt is the yield the company would pay on new borrowing today, not the historical coupon, and it is tax affected because interest is deductible. Weights should be market value and, strictly, the target capital structure rather than today's snapshot.
Use CAPM: cost of equity equals the risk free rate plus beta times the equity risk premium. The risk free rate is normally the ten year government bond yield in the currency of the cash flows. Beta measures sensitivity to the market. The equity risk premium is the excess return equities are expected to deliver over the risk free rate, historically in the region of 5% to 7%. A size premium or company specific premium is sometimes added for smaller or riskier names.
Levered beta, the observed beta, reflects both business risk and financial risk from debt. Unlevered beta strips out the debt effect to isolate business risk. To build a beta for your target you unlever each comparable using beta divided by [1 plus (1 minus tax) x D/E], take the median, then re-lever it at your target's own capital structure by multiplying by [1 plus (1 minus tax) x D/E]. This makes comparables usable despite each carrying different leverage.
Perpetuity growth, sometimes called Gordon growth: final year free cash flow x (1 plus g), divided by (WACC minus g). Exit multiple: final year EBITDA times a market multiple. Perpetuity growth is more theoretically consistent because it stays inside the DCF framework, while the exit multiple imports a market view that may not persist. Best practice is to run both and cross check: derive the implied exit multiple from the perpetuity method and the implied growth rate from the multiple method. If either looks implausible, an input needs revisiting.
Standard discounting assumes each year's cash flow lands as a single lump on the final day of the year, which understates value because real cash arrives throughout the year. The mid-year convention discounts using periods of 0.5, 1.5, 2.5 and so on instead of 1, 2, 3, treating cash as if received at the midpoint. It raises the valuation modestly, typically by a few percent. Apply it consistently, including to terminal value, or the result will be internally inconsistent.
An unlevered DCF discounts unlevered free cash flow at WACC and produces enterprise value directly, then bridges to equity value by subtracting net debt. A levered DCF discounts levered free cash flow, which is after interest and mandatory debt repayment, at the cost of equity, and produces equity value directly. The unlevered approach dominates in practice because it is independent of capital structure and therefore comparable across companies. The two should agree in theory if assumptions are consistent.
If the company has no debt and intends to stay that way, WACC collapses to the cost of equity, since the debt weight is zero. The subtlety is whether zero leverage is the right long run assumption. If the company would sensibly carry debt at maturity, many practitioners use a target capital structure based on industry peers rather than the current zero, because the discount rate should reflect how the business will be financed over the life of the cash flows.
Extremely, because terminal value usually represents 60% to 80% of total value and the perpetuity formula divides by (WACC minus g), a small number. If WACC is 9% and g is 2%, the denominator is 7%. Moving g up one point to 3% shrinks the denominator to 6%, raising terminal value by roughly 17% from that change alone. This is exactly why DCF outputs are presented as a sensitivity table across a range of WACC and g rather than as one number.
Either the market disagrees with your assumptions or you have made an error. Legitimate reasons include a genuinely different view of growth, margins or risk, information the market has not priced, or a control premium the DCF captures but the trading price does not. Less legitimate reasons include an overly generous terminal growth rate, a WACC that does not reflect real risk, or hockey stick projections. Treat a large gap as a prompt to interrogate your inputs before concluding the market is wrong.
Subtract total debt, subtract preferred stock, subtract minority interest, then add cash and equivalents. Debt and preferred are claims ranking ahead of common equity, minority interest represents the portion of a consolidated subsidiary the parent does not own, and cash is added back because it is a non-operating asset already excluded from the operating cash flows you discounted. Divide the resulting equity value by fully diluted shares, using the treasury stock method for options, to get value per share.
Every concept above maps to a module you can practise, with the numbers regenerating on each attempt.
Reading an answer once is recognition. Interviews test recall under pressure, so the questions regenerate with fresh numbers every run.
Start practising freeMixing levered and unlevered logic, most often by discounting unlevered free cash flow at the cost of equity instead of WACC, or by subtracting interest from unlevered cash flow. The second most common is a terminal growth rate above long run GDP, which implicitly assumes the company eventually becomes larger than the economy.
Long enough that the business reaches a steady state, usually five to ten years. A cyclical or high growth company may need longer so that the terminal year represents a normalised level rather than a peak or trough, because terminal value is calculated from that final year.
Yes, and that is expected rather than a flaw. Most of a going concern business value lies beyond any ten year window. It does mean the terminal assumptions deserve the most scrutiny, and that presenting a DCF as a range across WACC and growth is more honest than a single point estimate.