DISCOUNTED CASH FLOW

Discounted cash flow (DCF) is one of the most important concepts underlying financial decision making. Also known as the "time value of money," DCF applies to any situation in which money is paid at one point and received at a different point. DCF analysis is a capital budgeting technique used to quantify and assess the receipts and disbursements from a particular activity, project, or business venture. These cash flows are expressed in terms of constant dollars at the outset of the business activity, considering risk and return relationships and timing of the cash flows. Under DCF, each successive year's cash flow is discounted to a greater extent than the previous year's, due to the fact that it is received further out in time.

Discounted cash flow analysis is utilized in a wide variety of business and financial applications. Mortgage loans are probably the most common example. DCF analysis can also be used by investors when deciding whether to purchase shares of stock in a company. In addition, DCF analysis can help business managers decide whether to make a certain investment, or choose between two or more potential investments. One of the most useful applications of DCF analysis is for business valuation purposes. In order to determine the value of a business, an analyst calculates the present value of the company's future cash flows.

The most common form of business valuation using DCF involves company-produced forecasts of cash flow for the next five years, along with a "steady state" cash flow for year six and beyond. The analyst will calculate the present value of the first five years' cash flows, plus the present value of the capitalized residual value from the steady state cash flow. Under this methodology, all years of the company's future cash flows are impounded in the measure of value. Of course, it is critical that the cash flows are reasonably estimated, with due care given to the various factors that can affect future results of operations. The analyst must work with knowledgeable company management, and gain a thorough understanding of the business, its competitors, and the marketplace in general, in order to conduct a meaningful analysis.

CORNERSTONES OF DCF ANALYSIS

According to Ronald W. Hilton, author of Managerial Accounting, there are two primary methods of DCF analysis: the net-present-value method (NPV); and the internal-rate-of-return (IRR) method. Both of these methods are based on the same four assumptions:

1. All cash flows are treated as though they occur at the end of the year." The additional computational complexity that would be required to reflect the exact timing of all cash flows would complicate an investment analysis considerably," said Hilton. "The error introduced by the year-end cash-flow assumption generally is not large enough to cause any concern."
2. Cash flows are treated as though they were known with certainty, although Hilton noted that "risk adjustments can be made in an NPV analysis to partially account for uncertainty about the cash flows."
3. All cash inflows are reinvested in other projects that earn money for the company.
4. Cash is obtained through a perfect capital market.

Hilton admitted that "in practice, these four assumptions rarely are satisfied. Nevertheless, discounted cash flow models provide an effective and widely used method of investment analysis. The improved decision making that would result from using more complicated models seldom is worth the additional cost of information and analysis."

Both the NPV method and the IRR method of DCF analysis are used by companies in making investment decisions. The NPV method involves computing the net present value of a potential investment using the company's cost of capital as a discount rate. Under this method, the company should accept any investment that has a net present value greater than zero and reject any others. The IRR method involves computing the internal rate of return for a potential investment, or the discount rate that yields a net present value of zero for the project. Under this method, the company should accept any investment that has an IRR greater than or equal to the company's cost of capital, and reject any others.

DETERMINING DISCOUNT RATES

An important element of DCF analysis is the determination of the proper discount rate that should be applied to bring the cash flows back to their present value. Generally, the discount rate should be determined in accordance with the following factors:

• Riskiness of the business or project: The higher the risk, the higher the required rate of return.
• Size of the company: Studies indicate that returns are also related inversely to the size of the entity. That is, a larger company will provide lower rates of return than a smaller company of otherwise similar nature.
• Time horizon: Generally, yield curves are upward sloping (longer term instruments command a higher interest rate); therefore, cash flows to be received over longer periods may require a slight premium in interest, or discount, rate.
• Debt/equity ratio: The leverage of the company drives the mix of debt and equity rates in the overall cost of capital equation. This is a factor that can be of considerable importance, since rates of return on debt and equity within a company can vary considerably.
• Real or nominal basis: Market rates of interest or return are on a nominal basis. If the cash flow projections are done on a real basis (noninflation adjusted), then the discount rate must be converted to real terms.
• Income tax considerations: If the cash flows under consideration are on an after-tax basis, then the discount rate should be calculated using an after-tax cost of debt in the cost of capital equation.