Wednesday, 18 January 2012

Discounted Cash Flow Method

Discount Rate Definition: Discount rate, defined also as hurdle rate, is a general term for any rate used in finding the present value of a future cash flow. In a discounted cash flow (DCF) model, company value is estimated by discounting projected future cash flows at an interest rate. This interest rate is the discount rate which reflects the perceived riskiness of the cash flows.
Discount Rate Explanation:
Using discount rate, explained as the risk factor for a given investment, has many benefits. The purpose of discount rate is to account for the loss of economic efficiency of an investor due to risk. Investors use a discount rate because it provides a way to account and compensate for their risk when choosing an investment. This provides, with each choice, a buffer to provide for the chance of failure in an investment over time as well as many investments over a portfolio. Though risk is somewhat of a sunk cost it is still included to add a real-world element to financial calculations. It is a measure used to prevent one from becoming "calculator rich" without actually increasing personal wealth.

In DCF model, there are two methods to get discount rate: weighted average cost of capital (WACC) and adjusted present value (APV). For WACC, discount rate is calculated for leveraged equity using the capital asset pricing model (CAPM). For APV, discount rate, present value, and all else is calculated for all equity firms.

The Discount Rate should be consistent with the cash flow being discounted. For cash flow to equity, the cost of equity should be used. For cash flow to firm, the cost of capital should be used.

Discount Rate Formula:
A succinct Discount Rate formula does not exist. More, discount rate is included in the discounted cash flow analysis and is the result of studying the riskiness of the given type of investment. Two formulas provide a discount rate:

Weighted Average Cost of Capital (WACC) = E/V * Ce + D/V * Cd * (1-T)

Where:
E = Value of equity
D = Value of debt
Ce = Cost of equity
Cd = Cost of debt
V = D + E
T = Tax rate

(or)

Adjusted Present Value = NPV + PV of the impact of financing

Where:
NPV = Net Present Value
PV = Present Value

Discount Rate Calculation:
For WACC:

WACC = $10,000/$20,000 * $2,000 + $10,000/$20,000 * $1,000 * (1-.3) = $1,050,000

If:
E = $10,000
D = $10,000
Ce = $2,000
Cd = $1,000
V = $20,000
T = 30%

For APV:

APV = $1,000,000 + $50,000 = $1,050,000

If:
NPV = $1,000,000
PV of the impact of financing = $50,000

Discount Rate Example:
Donna is an analyst for an entrepreneur. Where her boss is the visionary, Donna performs the calculations necessary to find whether a new venture is a good decision or not. She does not need a discount rate calculator because she has the skills to provide value above and beyond this. Donna is the right hand woman to the entrepreneur which she aspires to be. She first needs to prove herself in the professional world.

Donna's boss wants to know how much risk he has taken on his last venture. He would like, eventually, to find the discount rate business valuation to judge levels for performance and new ventures alike.

Donna is given the financial information she needs for one venture. She finds the discount rate (risk) using the equation below:

WACC = $10,000/$20,000 * $2,000 + $10,000/$20,000 * $1,000 * (1-.3) = $1,050,000

If:
E = $10,000
D = $10,000
Ce = $2,000
Cd = $1,000
V = $20,000
T = 30%

Next, Donnas boss has her find the discount rate for another venture he is involved in. The results are below:

Adjusted Present Value = NPV + PV of the impact of financing

Where:
NPV = Net Present Value
PV = Present Value

Donna appreciates her experience with her employer. She is sure that with this experience she can find the path to mentor another just like her.

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