Discounted cash flow method of business valuation is based upon expected future cash flows and discount rates. This approach is easiest to use for assets and firms whose cash flows are currently positive and can be estimated with some reliability for future periods. Discounted cash flow method, relates the value of an asset to the present value of expected future cash flows on that asset. In this approach, the cash flows are discounted at a risk-adjusted discount rate to arrive at an estimate of value. The discount rate will be a function of the riskiness of the estimated cash flows, with lower rates for safe projects and higher rate for riskier assets. This approach has its foundation in the ‘present value’ concept, where the value of any asset is the present value of the expected future cash flows on it. Essentially, Discounted cash flow looks at an acquisition as a pure financial investment. The buyer will estimate future cash flows and discount these into present values. Why is future cash flow discounted? the reason is that a rupee in future is at risk of being worth less than a rupee now. There are some business based real risks like acquired company loosing a contract, or new competitor entering the market or an adverse regulation passed by government, which necessitated discounting of cash flows.
The discounted cash flow (DCF) model is applied in the following steps:
- Estimate the future cash flows of the target based on the assumption for its post-acquisition management by the bidder over the forecast horizon.
- Estimate the terminal value of the target at forecast horizon.
- Estimate the cost of capital appropriate for the target.
- Discount the estimated cash flows to give a value of the target.
- Add other cash inflows from sources such as asset disposals or business divestment’s.
- Subtract debt and other expenses, such as tax on gains from disposals and divestment’s, and acquisition costs, to give a value for the equity of the target.
- Compare the estimated equity value’ for the target with its pre-acquisition stand-alone value to determine the added value from the acquisition.
- Decide how much of this added value should be given away to target shareholders as control premium.
In preparation for the forecast of target cash flows under the bidder’s management, the historic cash flow statements of the target must be examined.
Target cash flows are generally forecast for the next five to ten years. In general, the longer the forecast horizon, the less accurate the forecast. Whatever the forecast horizon, the terminal value of the target at the end of that period based on free cash flows thereafter also needs to be forecast. Often this terminal value is based on the assumption of perpetual free cash flows based on the same level of operations as in the last year of the forecast period. The level perpetual cash flows are then capitalized at the cost of capital to yield the terminal value.
The cost of capital is the weighted average cost of capital (WACC), estimated from the target’s pre-acquisition costs of equity and debt.
WACC = Ke E/V + (1 – Tc) Kd D/V + KpP/V
Where
- Ke = cost of equity;
- Kd = cost of debt;
- Kp = cost of preference shares;
- E = market value of equity;
- D = market value of debt;
- P = market value of preference shares;
- Tc = corporation tax rate;
- V = E +D + P, the value of the firm.