Applying DCF Analysis


To develop a thorough understanding of how to apply discounted cash flow analysis, we will apply it to a hypothetical situation with a fictional company. A chain of coffee houses, Wide Awake, is considering expanding its network through the Strategic Alternative of acquiring a significant competitor, Caffeine City. Let's apply discounted cash flow analysis to estimate the intrinsic value of this alternative. The first step in the process is to identify all future cash inflows and outflows resulting from the SA.

Step 1: Determine Free Cash Flows

Cash inflows consist of all expected revenues earned from the implementation of a Strategic Alternative. Cash outflows are all costs incurred over the life of the strategic initiative. Cash outflows are divided into investment costs and operating costs. Investment costs are items that become assets or things that a business owns.

In this case, the acquisition price—which is considered our initial investment in this case—is $50 million. The annual free cash flows start at $16 million per year and grow at 10 percent annually. The company will be sold at year five for $75 million. Exhibit 11-1 is a simple time line illustrating the cash flows associated with this Strategic Alternative.

Exhibit 11-1: Projected cash flows for Caffeine City acquisition, version A.

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click to expand

end example

Step 2: Select a Discount Rate

Let's assume that the discount rate, or cost of capital, is 15 percent. To review how to arrive at an appropriate discount rate, please refer to the section on shareholder value analysis in Chapter 10.

Step 3: Compute the Net Present Value

In the final step, we will apply a 15 percent discount rate factor to calculate the present value of the free cash flows in each future time period (Exhibit 11-2). Following this, all cash flows—whether positive or negative—will be summed for all time periods in the analysis to arrive at the net present value (NPV) of the Strategic Alternative in question.

Exhibit 11-2: Computing net present value.

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Year

Cash Flow[*]

Discount Factor @ (15%)[**]

Present Value of Cash Flow[*]

0

($50,000)

1.0000

($50,000)

1

$16,000

0.8696

$13,914

2

$17,600

0.7561

$13,307

3

$19,360

0.6575

$12,729

4

$21,296

0.5718

$12,177

5

$75,000

0.4972

$37,290

NPV

$39,417

[*]Values in thousands of dollars.

[**]Discount rate factors can be found in corporate finance books when discount rate and number of time periods is known.

end example

According to our discounted cash flow analysis, the net present value of the acquisition is approximately $39.4 million. This means that the Strategic Alternative creates intrinsic value and will increase the shareholder value of Wide Awake by $39.4 million.

While this example proves that DCF analysis is a relatively straightforward method for estimating the future value created from a proposed SA, the method is not without its limitations. One of the most significant weaknesses is that the outcome is more substantially influenced by cash flows that occur further out in time, which are much more difficult to predict accurately. Essentially, the net present value hinges most on those cash flows that are harder to predict. In the Wide Awake analysis, the majority of the NPV was generated in year five. It also had the highest adjustment for risk. Additionally, selection of the discount rate is a highly subjective, unscientific process involving consideration of multiple variables. How much does the discount rate affect intrinsic value? Let's look at the impact of changing the discount rate on intrinsic value. For example, we could reduce the discount rate to 12 percent (Exhibit 11-3).

Exhibit 11-3: Computing net present value with a reduction in the discount rate.

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Year

Cash Flow[*]

Discount Factor @ (12%)[**]

Present Value of Cash Flow[*]

0

($50,000)

1.0000

($50,000)

1

$16,000

0.8929

$14,286

2

$17,600

0.7972

$14,031

3

$19,360

0.7118

$13,780

4

$21,296

0.6355

$13,534

5

$75,000

0.5674

$42,555

NPV

$48,186

[*]Values in thousands of dollars.

[**]Discount rate factors can be found in corporate finance books when discount rate and number of time periods is known.

end example

As further illustrated in Exhibit 11-4, the net present value increases by about $9 million with only a 3 percent reduction in discount rate (15 percent to 12 percent). As we can see, the change in the discount rate has a dramatic impact on value, particularly on the cash flows that come later in the time frame of the analysis. The most dramatic jump is in year five, with a $5.3 million dollar increase.

Exhibit 11-4: Present value of future cash flows.

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Year

Varying Discount Rates

Net Increase / (Decrease)

12%

15%

1

$14,286

$13,914

$ 372

2

$14,031

$13,307

$ 724

3

$13,780

$12,729

$1,051

4

$13,534

$12,177

$1,357

5

$42,555

$37,290

$5,265

NPV

$48,186

$39,417

$8,769

end example




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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