Discounted Cash Flow Analysis (DCF): The Analytical Foundation


Discounted cash flow analysis is a technique used to identify the value of a Strategic Alternative where future cash flows are discounted or converted to their present value. DCF is important in strategic planning because it translates the monetary impact of forward-looking decisions into today's value. We discussed the math for DCF in the last chapter; here we will talk about the process. The following three steps are used to conduct a discounted cash flow analysis:

  1. Calculate the cash flows. In arriving at the cash flows, the important things to remember are to be realistic and comprehensive. A test of realism is to provide numbers that the most conservative individual on your team will deem reasonable. In order to be comprehensive you need to make sure that you are capturing all the elements of the cash flow. The norm is that the staff will be good about making sure that the entire benefit dimension is accounted for and the cost side is not comprehensive. Remember to include all the investment and operating costs, as discussed in Chapter 10. This is a big issue in the evaluation of technology projects where costs are not fully sized, and initiatives are abandoned because of the high expense to develop and operate systems. As you move through this exercise, try to gain an understanding about the uncertainty of the cash flows. Your judgment on the accuracy of our estimates is input for the next step. Low levels of accuracy do not mean that the analysis is flawed. There are cases where large amounts of data are not available. Say you are evaluating outsourcing all your administrative functions—information technology, accounting, human resources, and purchasing. Let's assume that your company has not outsourced anything in the past and there are a limited number of companies that have done this. This case would be of lower accuracy because of the limited amount of experience that you can draw on. You may want to use financial modeling techniques to gain an additional understanding of the value impact.

  2. Select a discount rate. As discussed in the prior chapter, the discount rate is the rate used to adjust the future cash flows for risk. This is the driver of the adjustment for risk. Great care needs to be taken in the selection of this component since it has a large impact on the value of future cash flows. You will need to compare this case against other Strategic Alternatives to determine its relative risk. This comparison will drive the decision to attach a premium to the cost of capital.

  3. Compute the net present value. Net present value is simply the sum of all the cash flows. This represents the increase or decrease in value that can be attributed to the Strategic Alternative. If the net present value is positive, then the Strategic Alternative should be implemented. If the net present value is negative, then the Strategic Alternative should be not be pursued at the time of the analysis. Future conditions may change the economics of the alternative.




Translating Strategy into Shareholder Value. A Company-Wide Approach to Value Creation
Translating Strategy into Shareholder Value: A Company-Wide Approach to Value Creation
ISBN: 0814405649
EAN: 2147483647
Year: 2003
Pages: 117

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