Discounted Cash Flow (Discounted cash flow )
In finance, discounted cash flow analysis is a method of evaluating a project, company, or asset using the concepts of the time value of money. All future cash flows are figured and discounted to give their present values (PVs) - the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is considered as the value or price of the cash flows in question.
Using Discounted cash flow analysis to compute the net present value takes as input cash flows and a discount rate and gives as output a price; the opposite procedure of taking cash flows and a price and inferring a discount rate, is known as the yield. Discounted cash flow analysis is widely employed in real estate development, corporate financial management and investment finance.
The most widely employed method of discounting is exponential discounting, which values future cash flows as the amount of money would have to be invested currently, at a provided rate of return, to yield the cash flow in future." Other methods of discounting, such as hyperbolic discounting, are studied in academics and said to reflect intuitive decision-making, but are not in general employed in industry.
The discount rate employed is in general the suitable Weighted average cost of capital (WACC), that speculates the risk of the cash flows. The discount rate speculates two things:
ñ The time value of money i.e risk free rate, As per the theory of time preference, investors would instead have cash immediately than to wait and must therefore be compensated by paying for the delay.
ñ A risk premium speculates the extra return investors demand since they wish to be compensated for the risk that the cash flow might not come into being after all.
An alternative to substitute the risk in the discount rate is to employ the risk free rate, but multiply the future cash flows by the figured probability that they will occur (the success rate). This method, widely employed in drug development, is referred to as net present value (risk-adjusted NPV), and similar methods are employed to incorporate credit risk in the probability model of CDS valuation.
Shortcomings of Discounted cash flow
Commercial banks have widely employed discounted cash flow as a method of evaluating commercial real estate construction projects. This practice has two substantial defects.
a) The discount rate assumption relies on the market for competing investments at the time of the analysis, which would likely change, perhaps dramatically, over time
b) Straight line presumptions about income raising over ten years are in general established upon historic raises in market rent but never components in the cyclic nature of many real estate markets. Most loans are brought in during boom real estate markets and these markets by and large last fewer than ten years.
Using Discounted cash flow to analyze commercial real estate during any but the former years of a boom market will lead to overestimation of the asset.
Discounted cash flow models are knock-down, but they do have defects. Discounted cash flow is merely a mechanical evaluation tool, which makes it subject to the principle "garbage in, garbage out". Little alterations in inputs can result in large alterations in the value of a company. Instead of attempting to project the cash flows to infinity, terminal value techniques are often employed. A simple annuity is employed to estimate the terminal value past 10 years, for instance. This is done since it is harder to come to a realistic figure of the cash flows as time goes on requires computing the period of time likely to reimburse the initial expenditure.
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