Discounted cash flow (DCF) is the sum of a series of future cash transactions, on a present value basis. DCF analysis is a capital budgeting technique used to quantify and assess the receipts and disbursements from a particular activity, project, or business venture in terms of constant dollars at the outset, considering risk-return relationships and timing of the cash flows. Under DCF, each successive year's cash flow is discounted to a greater extent than the prior year, 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).
One of the most useful applications of DCF analysis is for business valuation purposes. Here the analyst calculates the present value of the company's future cash flows. The most common form of this analysis involves using 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 than 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. Collateral impacts of various decisions must be quantified and entered into the calculus of the overall cash flows.
ASSUMPTIONS OF DISCOUNTED CASH FLOW ANALYSIS
According to Ronald W. Hilton, author of Managerial Accounting, there are two primary methods of discounted cash flow analysis: Net-present-value method (NPV) and internal-rate-of-return (IRR) method. Principal assumptions of these methods are as follows:
* All cash flows are treated as though they occur at the end of the year.
* DCF methods treat cash flows associated with investment projects as though they were known with certainty, whereas risk adjustments can be made in an NPV analysis to account—in part—for cash flow uncertainties.
* Both methods assume that all cash inflows are reinvested in other projects that earn monies for the company.
* DCF analysis assumes 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."
DETERMINING DISCOUNT RATES An important element of discounted cash flow 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 (non-inflation 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.