DCF from first principles
Free cash flow, discount rates, terminal value.
- Unlevered FCF = EBIT(1−t) + D&A − capex − ΔNWC.
- Discount at WACC to get enterprise value, then subtract net debt.
- Terminal value dominates the output, so sensitivity tables are mandatory.
The mechanics
Project unlevered free cash flow: EBIT × (1 − tax) + D&A − capex − change in working capital.
Discount each year at WACC, add a terminal value, and sum. That gives enterprise value; subtract net debt for equity value.
WACC
WACC blends the cost of equity and the after-tax cost of debt, weighted by capital structure.
Cost of equity usually comes from CAPM: risk-free rate + beta × equity risk premium. Debt is cheaper because interest is tax deductible and lenders rank ahead of shareholders.
Terminal value
Gordon growth: final-year FCF × (1 + g) ÷ (WACC − g). Or exit multiple: final-year EBITDA × a chosen multiple.
Terminal value is often 60–80% of the total, which is the standard critique of the method: small changes in g or WACC swing the answer enormously.
Apply the lesson to explain free cash flow, discount rates, terminal value. Start with the answer, show the bridge, and sanity-check the direction before stopping.
- 1Lead with the definition or conclusion for dcf from first principles.
- 2Show the mechanics in a fixed sequence and state every assumption.
- 3Finish with the practical implication, risk, or reason the result matters.
Final-year FCF is $50M, WACC 10%, perpetual growth 2%. Terminal value?
You discount unlevered free cash flow at WACC. What do you get?
- Unlevered FCF = EBIT(1−t) + D&A − capex − ΔNWC.
- Discount at WACC to get enterprise value, then subtract net debt.
- Terminal value dominates the output, so sensitivity tables are mandatory.