Discounted Cash Flow - Methods of Appraisal of A Company or Project

Methods of Appraisal of A Company or Project

This is necessarily a simple treatment of a complex subject: more detail is beyond the scope of this article.

For these valuation purposes, a number of different DCF methods are distinguished today, some of which are outlined below. The details are likely to vary depending on the capital structure of the company. However the assumptions used in the appraisal (especially the equity discount rate and the projection of the cash flows to be achieved) are likely to be at least as important as the precise model used.

Both the income stream selected and the associated cost of capital model determine the valuation result obtained with each method. This is one reason these valuation methods are formally referred to as the Discounted Future Economic Income methods.

• Equity-Approach
  • Flows to equity approach (FTE)

Discount the cash flows available to the holders of equity capital, after allowing for cost of servicing debt capital

Advantages: Makes explicit allowance for the cost of debt capital

Disadvantages: Requires judgement on choice of discount rate

• Entity-Approach:

• Adjusted present value approach (APV)

Discount the cash flows before allowing for the debt capital (but allowing for the tax relief obtained on the debt capital)

Advantages: Simpler to apply if a specific project is being valued which does not have earmarked debt capital finance

Disadvantages: Requires judgement on choice of discount rate; no explicit allowance for cost of debt capital, which may be much higher than a "risk-free" rate

• Weighted average cost of capital approach (WACC)

Derive a weighted cost of the capital obtained from the various sources and use that discount rate to discount the cash flows from the project

Advantages: Overcomes the requirement for debt capital finance to be earmarked to particular projects

Disadvantages: Care must be exercised in the selection of the appropriate income stream. The net cash flow to total invested capital is the generally accepted choice.

• Total cash flow approach (TCF)

This distinction illustrates that the Discounted Cash Flow method can be used to determine the value of various business ownership interests. These can include equity or debt holders.

Alternatively, the method can be used to value the company based on the value of total invested capital. In each case, the differences lie in the choice of the income stream and discount rate. For example, the net cash flow to total invested capital and WACC are appropriate when valuing a company based on the market value of all invested capital.