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In Finance , the discounted cash flow (or DCF) approach describes a method to value a project or an entire company using the concepts of the Time Value Of Money . All future Cash Flow s are estimated and discounted to give them a Present Value . The discount rate used is generally the appropriate Cost Of Capital , and incorporates judgments of the uncertainty (riskiness) of the future cash flows. Discounted cash flow analysis is widely used in investment finance, Real Estate Development , and corporate financial management. MATHEMATICS The discounted cash flow formula is derived from the Future Value formula for calculating the Time Value Of Money and compounding returns. : The simplified version of the Discounted cash flow equation (for one cash flow in one future period) is expressed as: : where
Where multiple cash flows in multiple time periods are discounted, it is necessary to sum them as follows: For each future cash flow (FV) at any time period (t) for all time periods. The sum can then be used as a Net Present Value figure or used to further calculate the Internal Rate Of Return for a cash flow pattern over time. EXAMPLE DCF To show how discounted cash flow analysis is performed, consider the following simplified example.
Simple subtraction suggests that the value of his profit on such a transaction would be $150,000 - $100,000 = $50,000, or 50%. If that $50,000 is Amortized over the three years, his implied annual return (known as the Internal Rate Of Return ) would be about 13.6%. Looking at those figures, he might be justified in thinking that the purchase looked like a good idea. However, since three years have passed between the purchase and the sale, any cash flow from the sale must be discounted accordingly.
So, calculating exclusively for opportunity cost, we get a discount rate of 5% per year (taking the comparable-period Treasury rate of return directly). Using the DPV formula above, that means that the value of $150,000 received in three years actually has a Present Value of $129,576 (rounded off). Those future dollars aren't worth the same as the dollars we have now. Subtracting the purchase price of the house ($100,000) from the Present Value results in the Net Present Value , which would be $29,576 or a little more than 29%. Amortized over the three years, that implies a discounted annual return of 8.6% (still very respectable, but only 63% of the profit he previously thought he would have). Note that the original internal rate of return (13.6%) minus the discount rate (5%) equals the discounted internal rate of return (8.6%). The discount rate directly modifies the annual rate of return. But what about risk?
For the sake of the example, let's then estimate his risk factor is about 5% (we could perform a more precise probablistic analysis of the risk, but that is beyond the scope of this article). Therefore, this analysis should now include both opportunity cost (5%) and risk (5%), for a total discount rate of 10% per year. Going back to the DPV formula, $150,000 received three years from now and discounted at a rate of 10% is only worth $111,261 (rounded off) in present-day dollars. The present-value profit on the sale is now down to $11,261 discounted dollars from $50,000 nominal dollars. The implied annual rate of return on that discounted profit is now 3.6% per year. That return rate may seem low, but it is still positive after all of our discounting, suggesting that the investment decision is probably a good one: it produces enough profit to compensate for opportunity cost and risk with a little extra left over. When investors and managers perform DCF analysis, the important thing is that the net present value of the decision after discounting all future cash flows at least be positive (more than zero). If it is negative, that means that the investment decision would actually ''lose'' money even it appears to generate a nominal profit. For instance, if the expected sale price of John Doe's house in the example above was not $150,000 in three years, but ''$130,000'' in three years or $150,000 in ''five'' years, then buying the house would actually cause John to ''lose'' money in present-value terms (about $6,000 in the first case, and about $9,000 in the second). Similarly, if the house was located in an undesirable neighborhood and the Federal Reserve Bank was about to raise interest rates by five percentage points, then the risk factor would be a lot higher than 5%: it might not be possible for him to make a profit in discounted terms even if he could sell the house for ''$200,000'' in three years. In this example, only one future cash flow was considered. For a decision which generates multiple cash flows in multiple time periods, DCF analysis must be performed on each cash flow in each period and summed into a single Net Present Value . METHODS Depending on the financing schedule of the company four different DCF methods are distinguished today. Since the underlying financing assumptions are different they do not need to arrive at the same value of the project or company:
HISTORY Discounted cash flow calculations have been used in some form since money was first lent at interest in ancient times. As a method of asset valuation it has often been opposed to accounting book value, which is based on the amount paid for the asset. Following the stock market crash of 1929, discounted cash flow analysis gained popularity as a valuation method for stocks. Irving Fisher in his 1930 book "The Theory of Interest" and John Burr Williams 's 1938 text ' The Theory Of Investment Value ' first formally expressed the DCF method in modern economic terms. SEE ALSO
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