How do you calculate the discount rate and the future cash flows for the discounted cash flow method?
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The discount rate is the rate of return that you require to invest in a project, business, or asset. It reflects the opportunity cost of capital, the risk of the investment, and the time value of money. The higher the discount rate, the lower the present value of the future cash flows. There are different ways to estimate the discount rate, such as using the weighted average cost of capital (WACC), the capital asset pricing model (CAPM), or the internal rate of return (IRR).
The future cash flows are the estimated net amounts of money that you expect to receive or pay from the investment over a certain period of time. They include the initial outlay, the operating cash flows, and the terminal value. The initial outlay is the amount of money that you spend to acquire or start the investment. The operating cash flows are the annual net income plus the non-cash expenses, such as depreciation and amortization. The terminal value is the estimated value of the investment at the end of the projection period, either by using a multiple of earnings or a perpetual growth rate.
To calculate the present value of future cash flows, you need to apply the discount rate to each cash flow and sum them up. This can be done using the formula: Present value = CF0 + CF1 / (1 + r) + CF2 / (1 + r)^2 + ... + CFn / (1 + r)^n, where CF0 is the initial outlay, CF1, CF2, ..., CFn are the operating cash flows for each year, r is the discount rate, and n is the number of years. Alternatively, you can use a spreadsheet program such as Excel to perform the calculations. The
NPV
function can be used to calculate the present value of operating cash flows and add it to the initial outlay and the present value of the terminal value.
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Today I have this bank balance, tomorrow I will pay this amount of bills. I expect to receive this amount of payments.. Oops, didn’t realise I actually had a more simple formula for Cash Flow Planning than all that CF0 + CF1 / (1 + r) + CF2 / (1 + r)^2 + ... + CFn / (1 + r)^n, where CF0 is the initial outlay, CF1, CF2,…. bollox Happy to be working in my world ??
The DCF results tell you how much the investment is worth today based on your assumptions and expectations. You can compare the present value of the future cash flows with the current market value of the investment to determine if it is overvalued or undervalued. If the present value is higher than the market value, it means that the investment is undervalued and offers a positive net present value (NPV). If the present value is lower than the market value, it means that the investment is overvalued and offers a negative NPV.
The DCF method is a powerful tool for cash flow forecasting and valuation, but you should be aware of its limitations. It relies on many assumptions and estimates that may not be accurate or realistic, such as the discount rate, the growth rate, and the terminal value. Furthermore, it is sensitive to changes in the inputs, particularly the discount rate. This means that a small change in the discount rate can have a major impact on the present value. Moreover, the DCF method does not take into account other factors that could affect the value of the investment, such as market conditions, competitive advantages, or strategic synergies.
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It helps to vary the forecast by using a series of interest rates. This can simulate various future market conditions and show you at what rate it breaks-even and goes positive or negative. It is useful to know how sensitive your project is to interest rate changes.
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