Tuesday, January 20, 2009

Methods to Calculate Discount Rates - DCF

Discounted Cash Flow Analysis can be broken down into three sections:

1. Forecast free cash flows for a given period (5 to 10 years generally, and depending on the industry)
2. Discount free cash flows using some discount rate

3. Calculate the Net Present Value

A question you will probably encounter during interviews will be: What discount rate should you use when performing a DCF?

According to Wet Feet, you should know 4 different discounting methods: CAPM Model, WACC, Gorden Model, Hurdle Rate or Rule of Thumb.

1. CAPM Model - Calculating the return on equity (R
--- R
e = Rf + Beta (Rm - Rf)
--- Beta is a measure of how sensitive the equity price is to the market (also known as market risk)
(Rm - Rf) is known as the risk premium (generally 5%-9% depending on your source information)

2. WACC (Weighted Average Cost of Capital)
--- WACC = R
e*E / (D + E) + Rd (1 - Tc ) *D / (D + E)
--- R
e = return on equity
--- R
d = return on debt
--- E = market value of the equity
--- D = market value of debt (usually assume equal to BV
--- T
c = corporate tax tate

3. Gordon Model
--- R
e = D1/P0 + g
--- D
1 = next years' expected dividend
P0 = today's stock price
--- g = the expected growth rate of dividends
--- this model assumes a constant dividend payout ration and dividend growth into perpetuity

4. Hurdle Rate or Rule of Thumb
--- Determine some rate of return - say 12% - and only accept investment projects or opportunities that exceed that rate