The discounted cash flow method is the standard method of assessing the attractiveness of an investment among finance practitioners. The method's goal is to discount a stream of cash flows into present value terms to calculate a net present value. One of the key inputs is the discount rate used to convert each future cash flow into present value terms. While most practitioners use a uniform discount rate, there are situations when it may be more accurate to use multiple discount rates.
Identify the stream of cash flows. As with all discounted cash flow analyses, the first step is to determine the magnitude and timing of all cash flows, including any upfront and recurring investments. For calculation purposes, inflows are positive and outflows are negative.
Determine the riskiness of each cash flow. To select a discount rate for each of the cash flows, you must first assess the relative riskiness of the cash flows. If all the cash flows are equally risky in terms of their risk of being realized, a uniform discount rate is appropriate. However, if some of the cash flows are riskier than others, it is more accurate to use different discount rates for different cash flows.
Estimate the discount rate for each of the cash flows. Having established the riskiness of the different cash flows, proceed to calculate the discount rate. This can be accomplished in one of two ways: making a subjective judgment call or using the capital asset pricing model. The latter method is only applicable to listed securities in which you can estimate a beta and market risk premium.
Discount the cash flows to calculate a net present value. Apply the discounted cash flow method to convert each cash flow into present value terms. For example, if you have a cash flow of $1,000 to be received in five years' time with a discount rate of 10 percent, you would divide $1,000 by 1.1 raised to the power of five. Repeat this step for every cash flow and net out any investments.
Because the estimation of discount rates is so difficult, conduct a sensitivity analysis to evaluate a range of values.
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