You’re working on a DCF valuation for CloudCore Inc., a publicly traded cloud computing company. You’ve built a standard unlevered DCF model using a WACC of 10% and based on your 5-year forecast, the Enterprise Value (EV) currently comes out to $200 million.
1) Planned Data Center Investment
Partway through the project, CloudCore announces plans to build a new data center in Year 4, costing $100 million in cash, without any debt or lease financing. The company expects the investment to support future growth, but no additional revenue or cost savings will show up in the 5-year forecast.
How should you adjust your DCF model to reflect the planned data center investment?
You should include the $100 million cost as a capital expenditure in Year 4, which reduces the Free Cash Flow for that year by the same amount. This reflects the cash outflow needed to fund the investment, even if it doesn’t yet affect operating performance.
What is the impact of this adjustment on the company’s Enterprise Value?
The Enterprise Value will decrease by the present value of the $100 million CapEx in Year 4.
Because the $100 million happens in Year 4, we must discount it back to Year 0 using the formula:
Present Value = 100 / (1+r)^t
r = discount rate
t = time
Plug in the numbers:
100 / (1+0.10)^4 = 100/1.4641 ≈ 68.3
Original EV: $200 million
Subtract present value of CapEx: $68.3 million
New EV = 200 − 68.3 = 131.7 million
The revised Enterprise Value is approximately $131.7 million after accounting for the discounted cost of the data center investment.
The question tests whether the candidate understands how CapEx affects Free Cash Flow and how the timing of cash flows influences Enterprise Value through discounting. Look for clarity in logic and precision in applying the discounting formula, not just the final number.
2) Convertible Bonds in the Capital Structure
As you refine your WACC and move toward calculating per-share value, you review CloudCore’s capital structure. In addition to $100 million in standard debt, the company has:
- $50 million in convertible bonds with a conversion price of $10/share
- The current share price is $15
- The company has 20 million basic shares outstanding
- No options or warrants are outstanding
- $10 million in cash
How should you treat convertible debt?
It depends on whether the convertible debt is in-the-money or out-of-the-money:
- If the company’s share price is higher than the conversion price, the convertible debt is in-the-money. That means investors will likely convert it into stock, so we treat it as equity, not debt. It increases the company’s Equity Value and does not count toward the debt when calculating Levered Beta.
- If the share price is lower than the conversion price, the convertible debt is out-of-the-money. In that case, investors will keep it as debt, so we treat it like normal debt and include it in the debt portion of the WACC and Levered Beta calculation.
In this case, the convertible debt is in-the-money (since $15 > $10), so it’s treated as equity. You exclude the $50M from the debt portion and include it in Equity Value when calculating Levered Beta and WACC.
This question checks whether the candidate understands how hybrid securities like convertible debt impact capital structure assumptions in WACC. Look for clear conditional reasoning (in-the-money vs. out-of-the-money) and whether they correctly adjust the weighting between debt and equity when calculating Levered Beta.
Calculate the company’s Equity Value and per-share price based on your DCF.
To calculate the per-share value, we convert Enterprise Value to Equity Value by adjusting for cash, debt, and convertibles. While this can be circular in complex cases, here we assume full conversion since the convertible bonds are clearly in-the-money, so we can calculate the diluted share count directly.
Start with adjusted Enterprise Value:
EV = $131.7M
Add cash:
EV + Cash = 131.7 + 10 = $141.7M
Subtract net debt (excluding convertibles):
Debt = $100M (convertibles excluded as equity)
Equity Value = 141.7 – 100 = $41.7M
Add convertible debt to Equity Value (since it’s treated as equity):
Total Equity Value = 41.7 + 50 = $91.7M
Diluted shares outstanding:
Convertibles at $10/share = 50M / 10 = 5 million new shares
Total shares = 20M + 5M = 25 million shares
Per-share value:
91.7M / 25M = $3.67 per share
This question tests whether the candidate can bridge DCF mechanics with real-world equity valuation. Look for a clear understanding of how to move from Enterprise Value to Equity Value, handle dilution, and explain when circularity matters (even if iterative calculations aren’t required in this simplified case).
In more complex cases, why does calculating the per-share value become circular, and how does Excel handle this?
- Circularity happens when dilution depends on the share price, but the share price also depends on dilution.
- For example, options are only exercised if the share price is above the strike price.
- That means the number of shares changes depending on the result you’re trying to calculate.
- This creates a loop that can’t be solved with a single formula.
- Excel resolves this using iterative calculations, which update the share price and share count repeatedly until the numbers converge.
3) Timing of Cash Flows
Just before you finalize your report, a senior colleague challenges one of your modeling assumptions: “Are you assuming the company generates all its cash at the end of each year?”
Why might you consider applying the mid-year convention in this DCF?
- In reality, companies earn cash throughout the year, not just at year-end.
- The mid-year convention assumes even distribution of cash flows, so you discount them 0.5 years earlier (i.e. use periods of 0.5, 1.5, 2.5…).
- This typically results in a slightly higher present value, since cash is discounted over a shorter time.
- It’s a more accurate reflection of operating reality, especially for companies with steady, recurring revenue like CloudCore.
What discount periods would you use under the mid-year convention if your DCF starts with a stub period (for example, Q4 of Year 1)?
- For stub periods, you apply the mid-year adjustment proportionally.
- First, divide the stub period (e.g. 0.25 for Q4) by 2 → 0.125.
- Then subtract 0.5 from all normal full-year discount periods.
| Period | Normal Discount Periods | Mid-Year Discount Periods |
|---|---|---|
| Q4 (stub) | 0.25 | 0.125 |
| Year 1 | 1.25 | 0.75 |
| Year 2 | 2.25 | 1.75 |
| Year 3 | 3.25 | 2.75 |
| Year 4 | 4.25 | 3.75 |
| Year 5 | 5.25 | 4.75 |
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DCF Analysis at CloudCore Inc.