30 years: Financial markets trader
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.
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5 mins 23 secs
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.
Key learning objectives:
Learn how DCF is used to make an investment decision
Understand how investors renegotiate an investment opportunity
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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:
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.
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%.
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