Question

Explain the benefits of using the general valuation method of discounted cash flow as a tool for investment appraisal

Answer 1

Discounted cash flow (DCF) is the method of valuation in which the value of investment is calculated based on future cash flows. Using DCF, we can figure of the value of an investment today, based on the projections of amount/money generated in future. It gives the intrinsic value of any project or business based on fundamentals.

Advantages/ Benefits:

· It is the basic foundation tool which can be used both by financial investors and also by business owners who are looking to make changes in their businesses

· It is useful by business owners in making decisions like purchasing new equipment, replacing old machines, lease or buy decisions etc.

· DCF method uses the aspects of cost of equity, weighted average cost of capital, growth rate, re-investment rate etc. which helps to determine intrinsic value of business.

· Generally, Free Cash Flows are used in calculation which are the most reliable measure to know the projections of a business.

· DCF valuation can also be used as a sanity check to know the value of a company’s stock. Instead of estimating the fair intrinsic value, the current share price of the company can be plugged into the model, and working backwards, DCF model will tell how much the company’s stock is over-valued or under-valued, and also whether the current stock price is justified or not.

· It is useful to analyze the worth of a company in cases of mergers and acquisition.

· It can also be used to conduct sensitivity analysis.