It is a popular capital budgeting technique that takes into account the time value of money
It uses net present value of the investment project as the base to accept or reject a proposed investment in project
Net Present value (NPV)
If is the difference between the present value of cash inflows and outflows that occur as a result of undertaking an investment project
Positive NPV
If present value of cash inflows is greater than outflows, npv is said to be positive and the investment proposal is considered to be acceptable
Zero NPV
If present cash flow is, equal to outflow, npv is said to be zero and the investment proposal is considered to be acceptable
Negative NPV
If present value of cash inflow is less than outflow, the npv is, said to be negative and the investment proposal is rejected
Assumptions of NPV method
1) cash generated by a project is immediately reinvested to generate a return at a rate that is equal to the discount rate used in present value analysis
2) the inflow and outflow of cash other than initial investment occur at the end of each period
NPV calculation formula
Determine the current value for each years return and then use the expected cash flows and divide by discounted rate
NPV = Cash flow / (1 + rate of return) ^ number of time period
Internal rate of return (IRR)
If is the interest rate at which the net present value of all the cash flows from a project or investment equal to zero
IRR is used to evaluate the attractiveness of a project or investment
The investment should be rejected if the IRR is below the investors required rate of return
Rate of return (ROR)
It is the net gain or loss on an investment over a specified time period, expressed as a percentage of the investors cost
ROR = [ (current value – original value) / original value] X 100
Current value means current price of item
DCF Analysis
1) projections of the financial statements
2) calculating the free cash flows to firms
3) calculating the discount rate
4) calculating the terminal value
5) present value calculation
6) adjustments
7) sensitivity analysis
Small firms grow faster than more mature firms and thus carry higher growth rate
Projecting the income statement, balance sheet, cash flow statement
Free cash flow = EBIT X (1 – tax rate) + non cash charges + changes in working capital – capital expenditure
EBIT means earning before interest and taxes
Calculation of discount rate
Concept of weighted average cost of capital (WACC)
Cost of equity, debt
Calculating of terminal value
Terminal value or horizon value determines the value of business or project beyond the forecast period when the fire cash flows can be
Terminal value = final year projected cash flow * (1 + infinite growth rate) / (discount rate – long term cash flow growth rate)
Present value calculation
Present value is the current value of a future sum of money or stream of cash flows given a specified rate of return
Future value tells you what an investment is worth in the future
Present value tells you how much you need in today’s amount to earn a specific amount in future
Adjustments in DCF
If is to be done for all non-core assets and liabilities that have not been accounted for the free cash flow projections
Valuation may be adjusted by adding unusual assets or subtracting liabilities
Sensitivity Analysis
If is the study of how the uncertainty in the output of a mathematical model or system can be divided and allocated to different sources of uncertainty in its inputs
DCF helps to calculate the value of company today based on future cash flow
