Overview of the DCF Modelling Test for a Private Equity Fund

By completing this test, you will demonstrate your ability to apply real estate finance concepts to assess the viability of a property investment, both from a debt and equity perspective.

In this modelling test, you will be asked to build out a Discounted Cash Flow (DCF) model for a real estate investment, incorporating both equity and debt financing. The objective is to assess your ability to create a comprehensive financial model that reflects the cash flow dynamics, profitability, and financing structure of the investment.

The test will focus on two primary components:

1. Unlevered Cash Flow (Sponsor)
2. Levered Cash Flow (Equity Investor)

Both components will require you to project and calculate various financial metrics and inputs, including revenue, expenses, financing assumptions, and the final valuation based on DCF principles.

Test Objective:

The goal of this modelling test is to evaluate your ability to:

• Build a comprehensive and realistic financial model using DCF principles.
• Understand the interplay between debt and equity financing, and how it affects the cash flows available to both sponsors and investors.
• Project future cash flows accurately, ensuring all revenue, expenses, and financing assumptions are properly modeled.
• Evaluate the investment’s risk and return using metrics like NPV, IRR, and DCF valuation.

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Key Steps and Deliverables:

1) Unlevered Cash Flow (Sponsor)

This section reflects the cash flows generated by the property, excluding the effects of debt financing. You will project the following:

• Revenue: Rental income, other income, and any expected rent escalations.
• Operating Expenses: Property management, maintenance, taxes, insurance, etc.
• Net Operating Income (NOI): After subtracting operating expenses from revenue.
• Capital Expenditures (CapEx): Any anticipated costs for maintaining or improving the property.
• Free Cash Flow (FCF): The amount of cash available after operating expenses and capital expenditures but before debt servicing.

The Unlevered Free Cash Flow is critical because it shows the pure operational performance of the asset without the impact of debt financing. This will be used to estimate the property’s value through the DCF method, which discounts these future cash flows to their present value (PV).

2) Levered Cash Flow (Equity Investor)

This section reflects the cash flow to the equity holders, i.e., the sponsors or private equity investors, after accounting for the impact of financing. You will need to model:

• Debt Financing: Assume an appropriate loan structure, including interest rate, principal, and loan term. Model debt service (interest payments and principal repayment) based on the loan amortization schedule.
• Equity Investment: This reflects the sponsor’s or investor’s contribution to the deal and its required return on investment.
• Debt Service: Interest and principal payments on the loan, reducing the cash available to equity investors.
• Levered Free Cash Flow (LFCF): This represents the net cash flow after servicing both operating expenses and debt obligations.

The Levered Free Cash Flow will be used to calculate the equity value of the property, considering the investor’s cash return and the debt component.

3) Discounted Cash Flow (DCF) Analysis

For both unlevered and levered models, you will need to:

• Discount Future Cash Flows: Apply an appropriate discount rate to both unlevered and levered cash flows to calculate the Net Present Value (NPV).
• Terminal Value: Estimate the property’s value at the end of the investment horizon (usually at the time of sale or refinancing). This can be calculated using an exit cap rate or other appropriate methods.
• IRR (Internal Rate of Return): Calculate the IRR for both the unlevered and levered cash flows to evaluate the overall profitability and compare different financing structures.

Additional Tips for the Test:

• Double-check your assumptions: Make sure you clearly define the assumptions for revenue, expenses, debt terms, and exit strategy.
• Be mindful of the financing structure: Understand how debt impacts the cash flows to equity investors and affects the overall return.
• Understand key metrics: Focus on metrics like IRR and NPV to assess the investment’s attractiveness.
• Show your work clearly: Label all formulas and ensure that your model is easy to follow and understand.

This test will simulate a real-world scenario, so think like a real estate investor and ensure your model is comprehensive, accurate, and easy to interpret.