Walk Me Through a DCF: Interview Answer Framework
Master the DCF interview question with our complete framework. Learn to calculate free cash flow, WACC, terminal value, and handle follow-up questions.
"Walk me through a DCF" is one of the most fundamental valuation questions in finance interviews. Your answer demonstrates whether you understand how companies are valued at a core level. Here's how to nail it every time.
The Quick Answer (30 seconds)
Your Elevator Pitch
"A DCF values a company based on the present value of its future free cash flows. We project cash flows for 5-10 years, discount them back at the WACC, add a terminal value for cash flows beyond the projection period, and sum everything up to get Enterprise Value."
That's your foundation. Now let's build the complete understanding.
Step 1: Project Free Cash Flow
Free Cash Flow (FCF) represents the cash a company generates after investing in itself. We use Unlevered Free Cash Flow because it's available to all capital providers.
Unlevered FCF = EBIT × (1 - Tax Rate) + D&A - CapEx - ΔNWCThis measures cash flow available to all capital providers (debt + equity) before financing costs.
Test Yourself
Interview Question
A company has EBIT of $100M, tax rate of 25%, D&A of $20M, CapEx of $30M, and NWC increased by $5M. What is Unlevered Free Cash Flow?
Pro Tip
Why Unlevered?
We start with EBIT (before interest) because we're calculating cash available to ALL capital providers. Interest goes to debt holders specifically, so we exclude it. The WACC accounts for the cost of both debt and equity.
Step 2: Calculate the Discount Rate (WACC)
WACC (Weighted Average Cost of Capital) is the discount rate that reflects the blended cost of all capital sources.
WACC = (E/V × Re) + (D/V × Rd × (1 - T))Weight cost of equity and after-tax cost of debt by their proportions in the capital structure.
Test Yourself
Interview Question
Company has 70% equity weight, 30% debt weight, cost of equity 12%, cost of debt 6%, tax rate 25%. What is WACC?
Note
Why do we multiply Rd by (1-T)?
Interest expense is tax-deductible. If a company pays 5% interest and has a 25% tax rate, the after-tax cost of debt is only 3.75% (5% × 0.75). This tax shield makes debt cheaper than its stated rate.
Step 3: Calculate Terminal Value
Companies don't stop existing after 5-10 years. Terminal Value captures all cash flows beyond our projection period. Two approaches:
Gordon Growth Method (Perpetuity Growth)
TV = FCF_n × (1 + g) / (WACC - g)Assumes cash flows grow at a constant rate forever. Growth rate (g) is typically 2-3%, not exceeding long-term GDP growth.
Test Yourself
Interview Question
Final year FCF is $100M, perpetuity growth rate 2.5%, WACC 10%. What is terminal value?
Warning
Critical Rule: Growth rate must be LESS than WACC. If g ≥ WACC, the formula produces nonsensical results (infinite or negative values).
Step 4: Discount Everything Back
EV = Σ(FCF_t / (1 + WACC)^t) + (TV / (1 + WACC)^n)Sum the present value of all projected cash flows plus the discounted terminal value.
Step 5: Bridge to Equity Value
Equity Value = Enterprise Value + Cash - DebtDCF gives us Enterprise Value. To get Equity Value (share price), we adjust for net debt.
Test Yourself
Interview Question
DCF gives Enterprise Value of $500M. Company has $100M debt, $20M cash, and $10M preferred stock. What is Equity Value?
Key Sensitivities
Test Yourself
Interview Question
In a DCF sensitivity analysis, which two variables typically have the MOST impact on valuation?
What Drives DCF Value?
| Term | Definition | Note |
|---|---|---|
| WACC | Lower discount rate → Higher present value | Most impactful |
| Terminal Growth | Higher g → Higher terminal value | Extremely sensitive |
| Revenue Growth | Higher growth → Higher FCF → Higher value | High impact |
| Margins | Higher margins → More cash per dollar of revenue | High impact |
| CapEx Intensity | Lower CapEx → More free cash flow | Moderate |
When NOT to Use DCF
Test Yourself
Interview Question
Which company would be HARDEST to value accurately using a DCF?
DCF Limitations
DCF doesn't work well for:
- Companies with negative or unpredictable cash flows
- Early-stage startups without operating history
- Financial institutions (interest is core to operations)
- Distressed companies where terminal value is meaningless
- Businesses with binary outcomes (drug approval, hit product)
Common Mistakes to Avoid
Warning
- Forgetting to add back D&A when calculating FCF
- Using growth rate ≥ WACC in terminal value (mathematically impossible)
- Inconsistent cash flows and discount rates: UFCF with WACC, Levered FCF with Cost of Equity
- Terminal value too high: If it's over 80%, scrutinize your assumptions
- Projecting too far out: 5-10 years is standard; beyond that is too speculative
- Using book value of debt instead of market value in WACC
Putting It All Together
Your Complete Answer Framework
- Setup: "A DCF values a company based on present value of future cash flows..."
- Project FCF: "First, we forecast revenue and calculate unlevered free cash flow..."
- WACC: "We discount these at WACC, which blends cost of equity and after-tax cost of debt..."
- Terminal Value: "For cash flows beyond our projection, we calculate terminal value..."
- Sum Up: "We discount everything back and sum to get Enterprise Value..."
- Bridge: "Finally, we add cash and subtract debt to get Equity Value."
Practice this framework until it's second nature. The DCF question is foundational—interviewers expect you to know it cold.
Related Valuation Guides
Master valuation with these complementary guides:
- WACC Explained Simply — Deep dive into cost of capital calculations
- Enterprise Value vs Equity Value — The critical distinction for valuation
- EV/EBITDA Multiple Explained — When to use multiples vs. DCF
- Investment Banking Interview Questions — Full IB technical interview prep