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Discounted Cash Flow vs IRR

See Also:
Net Present Value versus Internal Rate of Return
Discounted Cash Flow Analysis
Internal Rate of Return Method
Net Present Value Method
Free Cash Flow Analysis

Discounted Cash Flow vs IRR

A lot of people get confused about discounted cash flow vs IRR and its relation or difference to the net present value (NPV) and the internal rate of return (IRR). In fact, the internal rate of return and the net present value are a type of discounted cash flows analysis. Both the NPV and the IRR require taking estimated future payments from a project and discounting them into the Present Value (PV). The difference in short between the NPV and the IRR is that the NPV shows a project’s estimated return in monetary units and the internal rate of return reveals the percentage return needed to break even. In fact, the IRR is the return needed for the NPV to hit 0. Further analysis of the difference between the NPV vs IRR can be found in the article NPV vs IRR.

If you want tips on how to manage your cash flow, then click here. You can also access our 25 Ways to Improve Cash Flow whitepaper here.

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Valuation Methods

See Also:
Financial Ratios
Required Rate of Return
Internal Rate of Return Method
EBITDA Valuation
What is a Term Sheet?
Adjusted EBITDA
Multiple of Earnings
Business Valuation Purposes

Valuation Methods

There are a variety of approaches to valuing a firm and its equity. Two of the most popular approaches are discounted cash flow (DCF) methods and market earnings multiple based methods.

Discounted Cash Flow (DCF) Methods

Discounted cash flow methods generally project future expected cash flows. This method accomplishes that by discounting the value of each of those flows to present value using a discounted rate. Then, the method takes the sum of those discounted values to represent the total value of the firm or the total value of the equity.

Free Cash Flow to the Firm (FCFF)

This Free Cash Flow to the Firm (FCFF) method arrives at a total firm value. Free cash flow to equity (FCFE) values the total equity in a firm.

Market Earnings Multiple Methods

Market earnings multiple methods typically project out a future adjusted earnings amount for the next twelve months. This earning amount typically uses EBITDA (earnings before interest, taxes, depreciation, and amortization) or net income. It then multiplies that earnings estimate by a multiple which is within the range of what other similar firms have sold for in recent transactions.

Valuation Methods Synopsis

As one might expect, valuations can often become complex. The subject of the proper discount rate has spawned numerous books itself. Valuation can also bring up contentious issues, particularly when the ownership interest represents a controlling stake or there is a less than liquid market for that interest.

When a valuation becomes complex, it is standard practice to consult with a valuation firm. If you need help finding one, then we will get you connected with one of our strategic partners for your valuation needs. Fill out the following form below to get connected:

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Discounted Cash Flow versus Internal Rate of Return (dcf vs irr)

See Also:
Net Present Value versus Internal Rate of Return
Discounted Cash Flow Analysis
Internal Rate of Return Method
Net Present Value Method
Free Cash Flow Analysis

Discounted Cash Flow versus Internal Rate of Return

A lot of people get confused about discounted cash flows (DCF) and its relation or difference to the net present value (NPV) and the internal rate of return (IRR). In fact, the internal rate of return and the net present value are a type of discounted cash flows analysis. Both the NPV and the IRR require taking estimated future payments from a project and discounting them into the Present Value (PV). The difference in short between the NPV and the IRR is that the NPV shows a projects estimated return in monetary units and the internal rate of return reveals the percentage return needed to break even. In fact the IRR is the return needed for the NPV to hit 0. Further analysis of the difference between the NPV vs IRR can be found in the article NPV vs IRR.

If you’re looking to sell your company in the near future, download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value. Don’t let the destroyers take money away from you!

Discounted Cash Flow versus Internal Rate of Return

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Discounted Cash Flow versus Internal Rate of Return

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Discounted Cash Flow Analysis

See Also:
EBITDA Definition
Steps to Track Money In and Out of a Company
Arbitrage Pricing Theory
Discount Rate
Required Rate of Return
(Discount Payback period) DPP

Discounted Cash Flow Analysis Definition

The definition of a discounted cash flow (DCF) is a valuation method used to value an investment opportunity. Discounted cash flow analysis tells investors how much a company is worth today based on all of the cash that company could make available to investors in the future. It requires calculation of a company’s free cash flows (FCF) in addition to the net present value (NPV) of these FCFs. There are three major concepts in DCF model: net present value, discounted rate and free cash flow. Estimate all future cash flows and discount them for a present value. Generally, use the discount rate as the appropriate cost of capital. It also incorporates judgments of the uncertainty of the future cash flows.


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Discounted Cash Flow Analysis Formula & Example

Use the following formula to calculate Equity Value:

Equity value = ∑Annual free cash flow to equity/(1 + cost of equity)^t + residual value/(1 + cost of equity)^t

Use the following formula to calculate Enterprise Value:

Enterprise value = ∑Annual free cash flow to firm/(1 + cost of capital)^t + residual value/(1 + cost of capital)^t

Or use constant-growth free cash flow valuation model when free cash flow grows at a constant rate g. The free cash flow in any period is equal to free cash flow in the previous period multiplied by (1+g).

Equity value = Annual free cash flow to equity * ( 1+ g)/(cost of equity – g)

Enterprise value = Annual free cash flow to firm * ( 1+ g)/(cost of capital – g)

Free cash flow to equity is the cash flow available to the company’s common equity holders after all operating expenses, interests, and principal payments have been paid. Necessary investments in working and fixed capital have also been made. It is the cash flow from operations minus capital expenditures minus payments to debt-holders.

Free cash flow to firm is the cash flow available to the company’s suppliers of capital after all operating expenses (including taxes) have been paid and necessary investments in working capital and fixed capital have been made. It is the cash flow from operations minus capital expenditures.

For example, a company is projected to have fluctuating cash flows. Losses of $10,000 in the first two years, a gain of $20,000 in year 3, $45,000 in year 4 and $ 55,000 in the year 5… How much is it worth today?

Discount the cash flows at a rate acceptable to the investor – 18%.

Time                 Year 1   Year 2   Year 3   Year 4   Year 5   NPV
Projected future cash flow       -10,000  -10,000  20,000   45,000   55,000
Residual value                                                        5,000
Projected annual free cash flow  -10,000  -10,000  20,000   45,000   60,000
Discounted cash flows            - 8,475  -7,182   12,173   23,211   26,227   45,953

This leaves a present value of $45,953. In conclusion, it indicates the estimated fair market value of the company today.

Discounted Cash Flow Analysis Applications

DCF valuation method used to estimate the attractiveness of an investment opportunity. Its analysis uses future free cash flow projections and discounts them to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, then the opportunity may be a good one.

Although DCF is good for investors to do a reality check, it does have shortcomings. DCF analysis is based on its input assumptions. For example, small changes in inputs (such as free cash flow forecasts, discount rates and perpetuity growth rates) can result in large changes in the value of a company. Investors must constantly second-guess valuations. This is because the inputs that produce these valuations are always changing and susceptible to error.

If you want tips on how to improve cash flow, then click here to access our 25 Ways to Improve Cash Flow whitepaper.

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Discount Rate

See Also:
EBITDA Definition
Cost of Capital Funding
Arbitrage Pricing Theory
Capital Budgeting Methods
Required Rate of Return

Discount Rate Definition

The discount rate definition, also known as hurdle rate, is a general term for any rate used in finding the present value of a future cash flow. In a discounted cash flow (DCF) model, estimate company value by discounting projected future cash flows at an interest rate. This interest rate is the discount rate which reflects the perceived riskiness of the cash flows.


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Discount Rate Explanation

Using discount rate, explained as the risk factor for a given investment, has many benefits. The purpose is to account for the loss of economic efficiency of an investor due to risk. Investors use this rate because it provides a way to account and compensate for their risk when choosing an investment. Furthermore, this provides, with each choice, a buffer to provide for the chance of failure in an investment over time as well as many investments over a portfolio. Though risk is somewhat of a sunk cost, still include it to add a real-world element to financial calculations. It is a measure used to prevent one from becoming “calculator rich” without actually increasing personal wealth.

In DCF model, there are two methods to get discount rate: weighted average cost of capital (WACC) and adjusted present value (APV). For WACC, calculate discount rate for leveraged equity using the capital asset pricing model (CAPM). Whereas for APV, all equity firms calculate the discount rate, present value, and all else.

The Discount Rate should be consistent with the cash flow being discounted. For cash flow to equity, use the cost of equity. For cash flow to firm, use the cost of capital.

Discount Rate Formula

A succinct Discount Rate formula does not exist; however, it is included in the discounted cash flow analysis and is the result of studying the riskiness of the given type of investment. The two following formulas provide a discount rate:

First, there is the following Weighted Average Cost of Capital formula.

Weighted Average Cost of Capital (WACC) = E/V * Ce + D/V * Cd * (1-T)

Where:
E = Value of equity
D = Value of debt
Ce = Cost of equity
Cd = Cost of debt
V = D + E
T = Tax rate

Then, there is the following Adjusted Present Value formula.

Adjusted Present Value = NPV + PV of the impact of financing

Where:
NPV = Net Present Value
PV = Present Value

Calculation

See the following calculation of WACC and APV.

For WACC:

WACC = $10,000/$20,000 * $2,000 + $10,000/$20,000 * $1,000 * (1-.3) = $1,050,000

If:
E = $10,000
D = $10,000
Ce = $2,000
Cd = $1,000
V = $20,000
T = 30%

For APV:

APV = $1,000,000 + $50,000 = $1,050,000

If:
NPV = $1,000,000
PV of the impact of financing = $50,000

Discount Rate Example

For example, Donna is an analyst for an entrepreneur. Where her boss is the visionary, Donna performs the calculations necessary to find whether a new venture is a good decision or not. She does not need a discount rate calculator because she has the skills to provide value above and beyond this. Donna is the right hand woman to the entrepreneur which she aspires to be. But she first needs to prove herself in the professional world.

Donna’s boss wants to know how much risk he has taken on his last venture. He would like, eventually, to find the discount rate business valuation to judge levels for performance and new ventures alike.

Donna’s boss gives Donna the financial information she needs for one venture. She finds the discount rate (risk) using the following equation:

WACC = $10,000/$20,000 * $2,000 + $10,000/$20,000 * $1,000 * (1-.3) = $1,050,000

If:
E = $10,000
D = $10,000
Ce = $2,000
Cd = $1,000
V = $20,000
T = 30%

Next, Donna’s boss has her find the discount rate for another venture that he is involved in. The results are below:

Adjusted Present Value = NPV + PV of the impact of financing

Where:
NPV = Net Present Value
PV = Present Value

Donna appreciates her experience with her employer. As a result, she is sure that with this experience she can find the path to mentor another just like her.

Discount Rate Definition, Discount Rate Formula, Discount Rate Example, discount rate

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Company Valuation Introduction

See Also:
Cost of Capital
Capital Asset Pricing Model
Common Stock
Cash Flow After Tax
Discount Rate
Why Valuation Matters
Valuation Methods
Liquidation Valuation

Company Valuation Introduction

How do you value a company and its equity? How do you calculate a company’s fair value? Have you overvalued or undervalued your company? As we dive into our company valuation introduction, we are going to look at the following are the three approaches to valuation:

DCF Approach

The most fundamental approach is DCF approach, which extends the present value principles to analyze projects to value a company. The following four factors determine the value of a company:

Market Valuation Multiples

Market valuation multiples which include the following:

Comparable Transactions

Comparable transactions approach of valuing a company involves using a price multiple to evaluate whether an asset is relatively fairly valued, or undervalued, or overvalued when looked at the comparable transactions that have taken place in the industry and compared to a benchmark value of the multiple.

Valuation can be difficult if you don’t have much experience. But with our guide, you’ll learn how to value your company AND remove any destroyers that are impacting your company’s value. Download the Top 10 Destroyers of Value to maximize the value of your company.

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Adjusted Present Value (APV)

See Also:
Adjusted Present Value Example
Cost of Capital Funding
Arbitrage Pricing Theory
Capital Asset Pricing Model
Capital Budgeting Methods
Required Rate of Return

Adjusted Present Value Definition

Adjusted present value (APV), defined as the net present value of a project if financed solely by equity plus the present value of financing benefits, is another method for evaluating investments. It is very similar to NPV. The difference is that is uses the cost of equity as the discount rate rather than WACC. And APV includes tax shields such as those provided by deductible interests. APV analysis is effective for highly leveraged transactions.

Adjusted Present Value Explanation

The adjusted present value approach is very similar to the Discounted Cash Flow method of valuation. So similar, in fact, that they will yield approximately the same results if the financing structure of a company is consistent. The method is especially effective in any situation in which the tax implications of a deal heavily effect the outcome, such as with a leveraged buyout. When compared to the more common methods of valuation, the adjusted present value method is newly created.


When valuing your company, it’s important to identify the destroyers in your company. 

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Adjusted Present Value Formula

The formula for adjusted present value is:

NPV (of a venture financed solely with equity capital) + PV of financing

APV Calculation

In the adjusted preset value (APV) approach the value of the firm is estimated in following steps.

1. The first step is to estimate the value of a company with no leverage by calculating a NPV at the cost of equity as the discount rate.

2. The next step is to calculate the expected tax benefit from a given level of debt financing. These can be discounted either at the cost of debt or at a higher rate that reflects uncertainties about the tax effects. The NPV of the tax effects is then added to the base NPV.

3. The last step is to evaluate the effect of borrowing the amount on the probability that the firm will go bankrupt, and the expected cost of bankruptcy.

In the adjusted present value (APV) approach, the primary benefit of borrowing is a tax benefit and that the most significant cost of borrowing is the added risk of bankruptcy.

If:
Investment = $500,000
Cash flow from equity = $25,000
Cost of equity = 20%
Cost of Debt = 7%
Interest on debt = 7%
Tax = 35%
Finance the deal half with equity and half with debt

NPV = -$500,000 + ($25,000 / 20%) = -$375,000
PV = (35% x $250,000 x 7%) / 7% = $87,500

-$375,000 + $87,500 = -$287,500 –> Bad Deal

APV Valuation vs Cost of Capital

In an APV valuation, obtain the value of a levered firm by adding the net effect of debt to the un-levered firm value.

In the cost of capital approach, the effects of leverage show up in the cost of capital, with the tax benefit incorporated in the after-tax cost of debt and the bankruptcy costs in both the levered beta and the pre-tax cost of debt.

These two approaches can get the identical results in theory. The first reason for the differences is that the models consider bankruptcy costs very differently, with the adjusted present value approach providing more flexibility in considering indirect bankruptcy costs whether or not it shows up in the pre-tax cost of debt. So the APV approach will yield a more conservative estimate of value. The second reason is that the APV approach considers the tax benefit from a dollar debt value, usually based upon existing debt. The cost of capital approach estimates the tax benefit from a debt ratio that may require the firm to borrow increasing amounts in the future. Download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value.

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LEARN THE ART OF THE CFO