A company reports $100M in net income, spends $80M on capital expenditures, and requires $30M in additional working capital to support its growth. What is its approximate free cash flow?
A$100M — net income represents the cash earnings available to shareholders
B$20M — free cash flow equals net income minus capital expenditures
C−$10M — free cash flow equals net income minus capex minus the working capital increase
D$50M — after adding back assumed depreciation of roughly $40M to net income
FCF = Net Income − Capital Expenditures − Increase in Working Capital = $100M − $80M − $30M = −$10M. Despite reporting $100M in accounting profit, this company generated negative free cash flow — it consumed more cash than it produced for shareholders. Option A conflates accounting earnings with cash; net income includes non-cash charges but excludes capex, which is a real cash outflow. Option B omits working capital changes. This negative FCF is a warning sign that the business requires heavy reinvestment just to sustain its reported earnings.
Question 2 Multiple Choice
An analyst values a high-growth company with DCF and finds that the terminal value accounts for 88% of the total valuation. A skeptical colleague says this means the model is unreliable. How should the analyst respond?
AAgree — a terminal value above 70% of total value indicates the discount rate is too low
BA high terminal value fraction is normal for growth companies; the right response is to stress-test terminal growth rate and discount rate assumptions with a sensitivity table
CReduce the terminal growth rate until the terminal value drops below 50% of total value
DReplace the terminal value with a price-to-earnings multiple to reduce model sensitivity
High terminal value fractions (often 70–90%) are normal in DCF analysis, especially for growth companies. Most of a company's value lies beyond the near-term forecast horizon. The appropriate response is not to suppress the terminal value but to acknowledge its sensitivity: show how total value changes across a range of terminal growth rates (g) and discount rates (r). The sensitivity table makes assumptions explicit and reveals the range of plausible outcomes — which is the real point of DCF analysis.
Question 3 True / False
Increasing the terminal growth rate from 3% to 4% has mainly a minor effect on intrinsic value because it mainly affects cash flows far in the future.
TTrue
FFalse
Answer: False
This is the key counterintuitive result of DCF: because terminal value uses the Gordon Growth Model formula TV = FCF/(r − g), a small increase in g (which appears in the denominator) has a disproportionately large effect. With r = 9% and g = 3%, the denominator is 6% — increasing g to 4% drops the denominator to 5%, a 17% reduction that increases terminal value by 20%. Since terminal value typically constitutes 70–90% of total firm value, this one-point shift in g can change total valuation by 15–35%. Terminal value sensitivity is not a minor issue — it is the central uncertainty in most DCF models.
Question 4 True / False
Free cash flow is a more reliable basis for equity valuation than net income because it removes non-cash charges and deducts actual reinvestment needs.
TTrue
FFalse
Answer: True
Net income includes depreciation (a non-cash charge that inflates reported earnings relative to cash) but excludes capital expenditures (a real cash outflow that reduces cash available to shareholders). A company spending its entire depreciation charge on capex to maintain assets is generating no economic surplus for shareholders, yet reports positive net income. FCF corrects both distortions: add back non-cash charges, then subtract actual cash reinvestment. The result is the true cash available to equity holders — which is what shareholders ultimately own a claim to.
Question 5 Short Answer
Why do DCF analysts typically present a range of valuations rather than a single number, and what does this practice reveal about the nature of the method?
Think about your answer, then reveal below.
Model answer: DCF valuations are highly sensitive to two assumptions that are inherently uncertain: the terminal growth rate g and the discount rate r. Both appear in the denominator of the terminal value formula (r − g), so small changes produce large valuation swings. A sensitivity table showing intrinsic value across a matrix of g and r values conveys the range of plausible outcomes and makes explicit what the analyst is betting on. This practice reveals that DCF's value is not in computing a precise answer — it is in disciplining your assumptions about long-run growth and risk and stress-testing which assumptions drive most of the value.
A single-point DCF estimate creates false precision. The sensitivity table is the honest representation of what the model can and cannot tell you. It also helps distinguish between cases where valuation is robust across a wide range of assumptions versus cases where it is highly dependent on a narrow set of optimistic inputs.