Question

Discounted cash flow analysis depends upon a large number of assumptions. Discuss the crucial assumptions in this case.

An assumption may be considered crucial when it is both empirically relevant (i.e., changing the assumption has a non-trivial effect on the answer) and cannot be precisely measured.

Answer 1

Discounted cash flow analysis is used to value a firm when its cash flows are already established and there is an existent and reasonable case for the cash flows to be projected and measured. As the name suggests, the method has three main components

a) Projected cash flows

b) Growth rate in cash flows

c) Relevant discount rate

In addition, while performing the discounted cash flow analysis, the cash flows beyond a certain time period cannot be estimated and is given either a constant growth or no growth as a firm is expected to have infinite existence. This is called Terminal value of valuation.

d) Terminal growth rate

For projected cash flows, the revenue drivers are assumed, the cost assumptions are input for projections as ratio of either revenue or assets, net working capital and capex are all assumed. For financing cash flows, relevant capital raising and repayment schedule are estimated.

For growth rate in cash flows, depending on the stage of growth , the growth rate is estimated. This growth rate can be subjected to change and thus there is flexibility in changing the assumptions

For the relevant discount rate, the cost of debt and equity are estimated. Cost of equity is most commonly estimated using CAPM.

The terminal growth rate is most commonly taken as the international growth rate or long term national growth rate if the firm is local.