Discounted Cash Flow Illustration (Equity)
After covering compounding and discounting, Abdulla explains how the discounted cash flow can be used to make a rational investment decision.
After covering compounding and discounting, Abdulla explains how the discounted cash flow can be used to make a rational investment decision.
Discounted Cash Flow Illustration (Equity)
5 mins 23 secs
Overview:
We value an equity stake of a company below by finding the present value of its future cash flows and calculating the net present value based on our initial investment.
How can DCF be used to make an investment decision?
Discounting future cash flows can be used to determine the viability of a project. As long as the NPV is 0 or positive, investors should consider it. They will need to know the size of the initial investment, the size and timing of cash flows and the discount rate.
Is a 25% equity stake in a company for £15,000 a good investment?
Using as the basis of the valuation:
- Ten years of free cash flow
- The numbers are accurate and occur on time
- The company has no debt and doesn’t pay a dividend
- Using a 5% discount rate (equivalent to your funding costs)
- Your required annual rate of return is 5% above funding costs
- Your discount rate is 10%
Using the discounting formula, the total PV of earnings comes to roughly £45,000; so a 25% stake is worth £11,326 – resulting in an NPV of -£3,674 (the PV minus the £15,000 investment). An investor should reject the offer.
How can investors renegotiate an investment opportunity?
An investor would be interested if the initial investment was £11,326 because at that level the NPV would be zero and the investors would be earning the required 10% return. Alternatively, by using the DCF formula, an investor can calculate how big a stake would be worth £15,000. The answer is 33.11%.