DCF interview questions
“walk me through a DCF” is probably the most common technical question in an investment banking interview – and the point where most candidates start to flounder. the discounted cash flow analysis isn't hard once you understand the logic instead of memorizing a formula. on this page we go through the building blocks, work through typical questions with full solutions, and show the mistakes that cost the most in an interview.
what a DCF is – and why banks love it
a discounted cash flow values a company based on the cash flows it generates in the future. the core idea: a euro tomorrow is worth less than a euro today, because money earns interest over time. so you project the future cash flows and discount them back to their present value. unlike comparables, the DCF is an **intrinsic** valuation – it depends on the company's fundamentals, not on current market sentiment.
in the interview, the DCF tests whether you cleanly connect three things: forecast, cost of capital and terminal value. anyone who can do this shows they really understand valuation – not just how to read off multiples.
the four building blocks of a DCF
1. free cash flow
the unlevered free cash flow is the starting point: EBIT × (1 − tax rate), plus depreciation, minus capital expenditure (capex), minus the change in net working capital. it shows how much cash the operating business generates for all capital providers – independent of financing.
2. WACC (cost of capital)
the weighted average cost of capital combines the cost of equity and the cost of debt, weighted by their share of the financing. the cost of equity is estimated via the CAPM: risk-free rate + beta × market risk premium. the cost of debt is taken after tax, because interest is tax-deductible.
3. terminal value
since you can't forecast cash flows individually forever, the terminal value bundles all cash flows after the forecast period. two methods: Gordon growth or exit multiple (see the FAQ below).
4. from EV to equity value
the sum of the present values gives the enterprise value. from this you subtract net debt (and adjust for minorities, pensions, etc.) to arrive at the equity value – the value that belongs to shareholders. divided by the share count, this gives the fair value per share.
example questions with solutions
“how do you calculate the unlevered free cash flow?”
solution: I start with EBIT and deduct the tax on it – so EBIT × (1 − tax rate). that gives NOPAT, the operating profit after tax without any financing effect.
then I add back depreciation, because it reduces profit but is non-cash. next I subtract capital expenditure (capex) and adjust for the change in net working capital: if working capital rises, cash is tied up, so it's a deduction. the result is the cash flow available to all capital providers.
“how is the WACC composed?”
solution: WACC = (E / (D+E)) × cost of equity + (D / (D+E)) × cost of debt × (1 − tax rate). E is the market value of equity, D that of debt.
I derive the cost of equity via the CAPM: risk-free rate (e.g. the yield on 10-year German government bonds) + beta × market risk premium. the beta measures how strongly the stock moves with the market. the cost of debt is the effective interest rate on the debt – after tax, because interest expense lowers the tax burden (tax shield).
“your terminal value is 80% of enterprise value. is that a problem?”
solution: not per se – for stable, growing companies a high terminal-value share is normal, because most of the value lies far in the future. but it is a warning sign for robustness: the result then depends almost entirely on two assumptions, WACC and the growth rate g.
in the interview I would say: “I would cross-check the terminal value with both methods – Gordon growth and exit multiple – and run a sensitivity analysis over WACC and g. if the value jumps sharply with small changes, I communicate a range rather than a point estimate.” this is exactly the caution banks want to see.
common mistakes in the DCF part
the classics: confusing levered and unlevered cash flow and discounting with the wrong rate; setting a terminal growth rate above GDP growth; forgetting to add back depreciation; or equating enterprise value with equity value. anyone who practices the LBO topic in parallel sees the connections faster – see our hub on LBO modeling interview questions. you'll find the complete overview of all topics in the guide to IB interview preparation, and if you're entering at the analyst level, it's worth a look at the analyst interview.
explain the DCF with confidence – under pressure.
practice DCF, WACC and terminal value with flashcards and worked solutions. 3 days with 50 cards free, over 1,200 cards with full access.
frequently asked questions about the DCF
because the unlevered free cash flow sits before interest payments and thus reflects the cash flow to all capital providers (equity and debt). it is consequently discounted with the WACC and leads directly to enterprise value. levered free cash flow, by contrast, belongs to the equity holders and is discounted with the cost of equity – that leads to equity value and is asked less often.
it falls. the WACC is the discount rate – the higher it is, the more future cash flows are discounted and the lower their present value. a higher WACC hits the terminal value especially hard, because it lies furthest in the future. that's why a DCF reacts very sensitively to small WACC changes.
first, the Gordon growth (perpetuity growth) method: last free cash flow × (1 + g) / (WACC − g), with a long-term growth rate g usually between 1% and 3%. second, the exit multiple method: an EBITDA multiple applied to the final forecast year. in practice you often calculate both and check that they land in a plausible range.
usually between 1% and 3% – it should not exceed the long-term inflation or GDP growth rate. a common mistake in the interview is a rate that's too high: if a company grows faster than the overall economy forever, it would eventually overtake it. that is economically impossible and is spotted immediately.
because it bundles all cash flows after the explicit forecast period – i.e. an infinite time span in a single number. depending on the company, the terminal value makes up 60% to 80% of enterprise value. that is at the same time the biggest weakness of the DCF: small assumptions about WACC and g have an enormous leverage effect on the result.
the usual explicit forecast period is five to ten years – long enough to bring the company to a steady state, short enough to keep the forecast reliable. everything after that sits in the terminal value. for young, fast-growing companies you tend to choose ten years, while for stable, mature companies five is often enough.