Join our investing community

IP 1 Assignment Query - Discounted Cash Flow (DCF)

Discussion in 'Financial Planning Study Group' started by Scotty1975, 4th Mar, 2010.

  1. Scotty1975

    Scotty1975 Member

    Joined:
    2nd Mar, 2010
    Posts:
    7
    Location:
    Adelaide, SA
    Hi all,

    Just a quick query.

    Im stuck with the following question in regards to my assignment and I cant seem to find the answer anywhere in my book. The question is:

    What impact does increasing the discount rate have on the results of a DCF valuation?

    Can anyone provide any insight or tell me where in the text it refers to this.

    Cheers

    Scott
     
  2. CJ. Wentworth

    CJ. Wentworth Well-Known Member

    Joined:
    9th Mar, 2008
    Posts:
    92
    Location:
    Cairns, QLD
    Scott I can't remember where exactly in the study notes the relevant information is sorry, but it helps to know what you're using the DCF in the first place.

    The DCF discount rate is a rate you discount future income by to bring it into todays dollars. You could effectively pull any figure out of thin air, but for more sensible reasons you could use something like the current inflation rate or CPI.

    For simple math look at the following equation

    A = B / C

    The larger C becomes, the lower A will be. Effectively, raising C lowers A. That makes sense. In this case C would include your discount rate.

    Now the question is why that rate is raised. Are interest rates trending upwards? Has CPI or inflation risen? Are the borrowing costs higher on one investment than another?

    In particular with the last question, DCF calculations are also used to compare two investments. It could be used to compare the value of an investment property, to a share portfolio. The interest rates on property loans tend to be much lower than those for shares, and the discount rates used will reflect this.

    The DCF rate used to evaluate property will generally be lower than that for shares because the costs involved in borrowing money for shares tends to be higher.



    I really hope that some of that made sense. Please always feel free to shoot me an email at cj.wentworth@live.com or add me to MSN and shoot off an offline email (I tend not to check too often).
     
  3. SteelMonkey

    SteelMonkey Member

    Joined:
    11th Feb, 2009
    Posts:
    17
    Location:
    Perth, WA
    Hi Scotty

    The DCF explanation is back in module 2 ' The Mathematics of Investment' its in section 2:9 - Discount rate and discounted cash flows in my study notes.

    I think we have the same notes and, if we do, it is on page 2:14

    Hope this helps!