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- Understanding Fair Market Value Business Valuation
- The Complete Guide to Business Valuation: Types, Methods, and Considerations
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After reading this article, you should be Apple to learn:
- What is Reduced Cash Flow
- Methods Used for Discounted Cash Flows
- How to Calculate Discounted Cash Flow
- Importance of Discounted Cash Flow
- Limitation of reduced cash flow
- FREQUENTLY ASKED QUESTIONS
What is Reduced Cash Flow (DCF)
Discounted cash flow is a technique used to evaluate and evaluate proposed investments, in order to decide whether they are worth the financial investment or not. This technique involves suppressing future cash flows by using a discount rate to assess the value of the investment at the current date based on the cash flows that will be generated in the future. If the present value of future cash flows exceeds the cost of the investment, this indicates that the project has a positive return. This tool is used in business investment decision. The DCF model is used in financial models to assess the valuation of performing investments.
Discounted Cash Flow Methods
There are two discounted cash flow methods for valuing proposed investments:
- Net present value (NPV) method: The net present value (NPV) is the difference between the present value of the cash outflows and the present value of the cash inflows during the time period. In this discounted cash flow method, the cost of capital (R) is the return required by the investor or business.
With this approach, a present value is given to the expected costs of the project and the expected benefits. The value of the project is measured as the net present value (the present value of the income or benefits minus the present value of the costs). The project should be undertaken if it adds value. It adds value if the net present value is positive (greater than 0).
Or:
- Internal Rate of Return (IRR):
The internal rate of return is used to assess the reduced rate, the present value of all future cash flows is equal to the initial capital investment. With this approach, the expected return on investment over the lifetime of the project is calculated and compared to the required minimum return on investment. The project would be undertaken if the expected output exceeds the required output. Other IRR methods include Modified Internal Rate of Return (MIR) and Economic Internal Rate of Return (EIRR).
How to Calculate Reduced Cash Flow
Discounted cash flows can be calculated using the following steps:
Example: A company with a cost of return of 10% plans to invest in a project with the following cash flows.
When you add up all the discounted cash flows, we get a net present value (NPV) of 2,068. This is a positive number, a wicked investment today of 10,000 is valid because the project will generate positive discounted cash flows above the initial cost.
An important issue to decide is what discount rate a company should use to calculate present values. Companies use the weighted average cost of capital (WACC) to reduce cash flow. WACC is essentially the weighted average of the cost of capital and the cost of debt. In fully shareholder-funded companies, the cost of equity is essentially the WACC and similarly, in case of fully loan-funded financing, the cost of debt will be the WACC. The higher the WACC means that the present value of the cash flows will be lower than if the same cash flows are discounted down the WACC.
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Importance of Reduced Cash Flow
The main importance of a discounted cash flow is that it is more objective than other methods of investment fitness.
Here are some of the benefits of discounted cash flow:
- Cash discount techniques are based on cash flows rather than accounting profits which are easier to manipulate and harder to interpret.
- It is used to analyze different types of companies or investments in a project and to obtain a satisfactory evaluation for each of them.
- DCF does not require market share or market value comparison with other companies.
- It provides a single absolute value that indicates the amount by which the project should add value to the business.
- The DCF decision rule is consistent with the goal of maximizing shareholder wealth.
- It helps company stakeholders to judge whether a company should merge or acquire another company.
Reduced Cash Flow Limits
Although discounted cash flows are useful in valuing the proposed investment in a project, it has certain limitations and cannot be used to value the investment with full accuracy.
Few basic limitations are explained below:
- The DCF involves numerous estimates, judgments and assumptions. The investor can correctly estimate the future cash flows of the proposed project or investment. Future cash flows would depend on many other factors, such as competition among investors, demand and supply, growth rate, and undetected internal or external opportunities and threats.
- Discounted cash flow is the concepts that are not easily understood by those without financial education. Decision makers tend to be smart, educated people.
- There could be some uncertainty about the appropriate cost of capital or discount rate should be to apply to any project. An approach like NPV or TRI would give a perfect answer in a perfect world, but businesses don’t operate with perfect information, which undermines the usefulness of the NPV or IRR approach.
- The discounted cash flow analysis required a significant amount of financial data, including capital expenditures and project benefits over several years. For the investor, it can be difficult to consolidate all the necessary data
FREQUENTLY ASKED QUESTIONS
Q. Is discounted cash flow an accounting concept?
A. No. Discounted cash flow is a concept in corporate finance decision making and used by investors to evaluate the company and decide whether or not to invest in a project.
Q. What is the sunk cost and if the sunk cost is part of discounted cash flow?
A. Sunk cost, also called irrelevant cost, is a cost that occurred in the past and it does not affect future cash flows. Hence, while deciding a project based on the DCF method, the sunk cost or historical costs will not be part of the future inflows and outflows. For example, a restaurant wants to open a new franchise and has spent ,000/- on marketing. For some reason the franchise opening plan is postponed and after two years the restaurant wants to value the business again in this new location by discounted cash flow, the cost of ,000/- is now a historical cost and should not be taken into account when making a decision, Future forecast entries and exits must be taken into account when making a decision.
Q. What is sensitivity analysis?
A. Because the discounted cash flow valuation method uses estimates and certain assumptions are important and may affect the investor’s decision. Therefore, when creating financial models, sensitivity analysis is performed. It indicates the impact of a specific assumption on the present value of the investment if all other assumptions are the same. Suppose a restaurant business has estimated the growth rate of 4% over the years, the sensitivity analysis will be performed to assess the value of the investment if the growth rate is reduced to 3% and all other assumptions are the same.
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