Disconted Cash Flow

Disconted Cash Flow

A Discounted cash flow valuation is a valuation method where future cash flows are discounted to present value. The valuation approach is widely used within the investment banking and private equity industry. In discounted cash flow valuation, the value of any asset can be written as the present value of the expected cash flows on that asset. Thus, the value of a default free government bond is the present value of the coupons on the bond, discounted back at a riskless rate. As we introduce risk into the cash flows, we face a choice of how best to reflect this risk. We can continue to use the same expected cash flows that a risk-neutral investor would have used and add a risk premium to the risk free rate to arrive at a risk adjusted discount rate to use in discounting the cash flows. Alternatively, we can continue to use the risk free rate as the discount rate and adjust the expected cash flows for risk; in effect, we replace the uncertain expected cash flows with certainty equivalent cash flows. We buy most assets because we expect them to generate cash flows for us in the future. In discounted cash flow valuation, we begin with a simple proposition. The value of an asset is not what someone perceives it to be worth but is a function of the expected cash flows on that asset. Put simply, assets with predictable cash flows should have higher values than assets with volatile cash flows. There are two ways in which we can value assets with risk: The value of a risky asset can be estimated by discounting the expected cash flows on the asset over its life at a risk-adjusted discount rate. Alternatively, we can replace the expected cash flows with the guaranteed cash flows we would have accepted as an alternative (certainty equivalents) and discount these certain cash flows at the risk free rate.
By combining assessments of both opportunity cost and risk, a discount rate is calculated for the analysis of present value of anticipated future cash flows. Free cash flow...