Series 79 practice questionhardDCF Analysis
An investment banker is performing a DCF on a cyclical industrial company currently at peak earnings. Which of the following adjustments would be most appropriate?
- AApply a premium to the discount rate to account for cyclicality
- BUse the most recent fiscal year's EBITDA as the basis for all projected years
- CNormalize earnings across the cycle and use a mid-cycle projection as the baseline for the terminal year✓ Correct answer
- DShorten the projection period to 3 years to reduce forecast uncertainty
Explanation
Why C — Normalize earnings across the cycle and use a mid-cycle projection as the baseline for the terminal year
For cyclical companies, using peak earnings as the baseline would overstate the terminal value and overall DCF valuation. The best practice is to normalize earnings across the business cycle so the terminal value reflects sustainable mid-cycle profitability. This avoids embedding temporary peaks or troughs into the perpetuity calculation. Adjusting the discount rate alone does not adequately address the issue of using inflated cash flows in the terminal value.
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