Question

Explain best practices for conducting Discounted Cash Flow Analysis, explain the limitations of DCF methodology, provide detailed explanations of the following key components:

a. Forecast Period b. Discount Rate c. Terminal Value

Answer 1

Best practises for DCF are:

• Consider operating cash flow over PAT
• Post-tax cash flows are even better than pre-tax cash flows
• A scenario analysis should be done with probabilities of occurrence
• If any extra risk is associated with the project then the discount factor has to be adjusted accordingly otherwise WACC is considered to be as the discount rate

Limitations of DCF:

• Future cash flows depend on several factors like demand, economic conditions so they will vary in future
• Estimation of FCF could lead us picking a project which cannot generate cash flow after certain years
• Determining an accurate discount factor is a tedious task

a) Forecast period - The time period for which the project will be generating Cash flows and hence these individual free cash flows are taken as input to DCF formula

b) Discount Rate - The interest rate at which the future free cash flows determined or estimated will be discounted to find the Net Present Value of the project. Generally, it is the weighted average cost of capital for the company.

c) Terminal Value - The cash flow that will be generated at the end of the period or beyond the forecasting period generally done by selling the asset at its salvage value. It is also considered while calculating the NPV of a project.