A discounted cash flow, or DCF, analysis is often used to estimate how attractive an investment opportunity might be. Properly handled, a DCF analysis can offer a projection of future free cash flows and estimate both the current and future value of that cash. If the present value determined by the analysis is less than the investment cost, the opportunity might not prove very lucrative.
Free cash flow is derived by determining how much cash a company has that is not needed to meet its commitments and is a major indicator of the value of the company's stock. Free cash may go to equity or to the company and are represented by the acronyms FCFE and FCFF, respectively. When analysts examine the projections for a company's future cash flows using the DCF, they calculate how much that future cash is worth in current terms; this is the net present value, or NPV. Returns are based on the weighted average cost of capital, or WACC, and the required return on equity, or RRE.
Free Cash Flow Basics
To obtain a discounted cash flow, you must first find the free cash flow. Free cash flow computations are based on the company's operating income after taxes. Depreciation is deducted from capital expenditures and the result, along with any change to the firm's working capital, are deducted from income. This yields the FCFF. Factoring out cash committed to or received from debt provides the FCFE; this requires subtracting payments for principal and interest and adding back cash received from new debts.
Discounted Cash Flow Basics
Once the FCFF or FCFE has been found, it is time to determine the NPV. The rate used should be based on the risk of cash flows rather than the risks involved with the company as a whole. The time value should be based on the investment cost. The NPV method is the most reliable way to determine the DCF, but the internal rate of return, or IRR, method is sometimes used as well.
Adding Back Accrued Interest
Because cash flows are based on operating revenue, interest was removed from the calculations earlier and the after-tax income was determined. Once you have established the DCF, you can add back accrued interest. However, you must adjust the amount of the interest to reflect the impact it will have on taxable income. Suppose your firm uses 30 percent as your corporate tax rate. Interest that you will be paying out will decrease your taxable income. If you have an interest accrual of $100, you would add back only $70 to obtain an accurate picture.
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