I have a funny story to tell - once I was explaining the result of a project feasibility analysis to our development team and one guy asked me to explain the calculation of net present value. So, I started explaining him in the simplest way possible. He was curious, so I was happy. Then suddenly he interrupted me and asked, “But why are we giving discounts?”
Nonetheless, even we professionals make mistakes. In one of the previous posts about the equity NPV, I discounted the equity cash flow at the weighted average cost of capital (WACC). Our reader, Srihari pointed that it should be discounted at the cost of equity and not at WACC.
The purpose of this post is to explain the concept of discounted cash flow analysis for project appraisal and valuation. Before you go through this post, you may like to see the definition and calculation of Net Present Value (NPV). Also if you are looking to review the basics concepts of real estate finance, you should download this Real Estate Finance Terms e-book.
Discounted cash flow analysis is a method of valuing projects or other assets using the concepts of the time value of money. The basic premise of time value of money is that a dollar today is worth more than a dollar in the future. How much more? Depends on your discount rate.
In the discounted cash flow analysis (DCF), the future cash flows generated by the project are estimated and discounted to give the present values. The sum of present value of the future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value of the project or asset.
So, what is the discount rate and how to calculate it?
Discount rate is used to find the worth of future cash flows. The discount rate reflects two things:
- Time value of money (risk-free rate) – according to the theory of time preference, investors would rather have cash immediately than having to wait and must therefore be compensated by paying for the delay.
- A risk premium – reflects the extra return investors demand because they want to be compensated for the risk that the cash flow might not materialize after all.
Two methods to calculate discount rate:
- Capital Asset Pricing Model (CAPM)
Discount Rate = Risk free Rate (Rf) + Risk Premium (Rm-Rf) X Beta (b)
- Weighted average cost of capital (WACC)
WACC = E/(E+D)*Re + D/(E+D)*Rd*(1-t)
Re = Rf + b (Rm-Rf)
In this post I will not go into further discussion about how to calculate the discount rate, but will focus on the equity valuation (NPV) versus project valuation (NPV). Many professionals make this mistake of discounting both project cash flows and equity cash flows at the same discount rate.
Equity NPV or Value of the Equity Stake in the Project:
The value of equity is calculated by discounting the cash flows to equity holders. It should be noted that these cash flows should be discounted at cost of equity and not at weighted average cost of capital (WACC).
Project NPV or Value of the Project
Project NPV or the value of the project is calculated by discounting the cash flows to the project, i.e., the residual cash flows after meeting all operating expenses and taxes, but prior to debt payments, at the weighted average cost of capital (WACC).
The key error to avoid is mismatching cash flows and discount rates. Since discounting cash flows to equity at the weighted average cost of capital (WACC) will lead to an upward biased estimate of the value of equity, while discounting cash flows to the project at the cost of equity will give a downward biased estimate of the value of the project.
Hope you enjoyed this post on discounted cash flow analysis, use the comment section below to let me know your thoughts.