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Discounted cash flow is what someone is willing to pay today in order to receive the anticipated cash flow in future years. It is the method most often used by large investment banks and consulting and accounting firms. The discount rate is based on the level of risk of the business and the opportunity cost of capital. In other words, it is the return you can earn by investing your money elsewhere.
In his book Creating Shareholder Value, Alfred Rappaport states:
The appropriate rate for discounting the companys cash flow stream is the weighted average of the costs of debt and equity capital. For example, if a companys after tax cost of debt is 6% and its estimated cost of equity is 16% and it plans to raise capital 20% by way of debt and 80% by way of equity, it computes the cost of capital at 14% as follows:
Weight Cost Weighted Cost
Debt 20% 6% 1.2%
Equity 80% 16% 12.8%
Cost of Capital 14.0%
The use of discounted cash flow is a hotly debated subject among those in the mergers and acquisitions business, particularly in the middle market. Its use is widely accepted with larger companies because it provides a rational economic framework for valuing acquisitions in that marketplace.
In the book Mergers & Acquisitions: A Valuation Handbook, Joseph H. Marren states,
One of the complexities with using the net present value method is that a target companys future cash flow depends on the method of acquisition and the purchase price. How? A target companys future cash flows are directly impacted by the taxes it will pay. The taxes it will pay depend on the companys taxable income. And the companys taxable income will depend, in part, on its taxable deductions for depreciation and the amortization of intangible assets. Such deductions depend on the targets tax basis for its assets, which in turn depend directly on the purchase price paid for the business.
Other opponents of the discounted cash flow method do not believe in paying for earnings that are not earned. Furthermore, the projections are speculative, and the selection of the discount