Discounted Cash Flow (DCF)

Question 1

Tell me about discounted cash flow and when they are generally used

Answer 1

• Growth implicit investment valuation approach
• Involves projecting estimated cash flows over an assumed holding period plus an exit value at the end of that period, usually arrived at on a conventional ARY basis. The cash flow is then discounted back to the present day at a discount rate (IRR/TRR) that perceived the investors targets and perceived level of risks
• Used for some alternative investments – income strips
• Short leasehold interests and properties with complex tenure or voids
• Nonstandard investments i.e. rent review patterns
• Phased development projects

Question 2

What is the simple methodology of a DCF valuation?

Answer 2

1. Estimate the cash flow – income, expenditure, the price you pay the for the property as a negative outflow
2. Estimate the exit value at the end of the holding period
3. Select the discount rate
4. Discount the cash flow at the discount rate
5. Value is the sum of the completed discounted cash flow to provide the NPV

Question 3

What is the Net Present Value and how can it be interpreted?

Answer 3

• The NPV is the sum of the discounted cash flows of a project
• Used to determine if an investment gives a positive return against a target rate of return
• NPV = positive – investment has exceeded the investors target rate of return
• When NPV is negative it has not achieved the target rate of return

Question 4

What is the IRR and how can it be interpreted?

Answer 4

• The rate of return at which all future cash flows must be discounted to produce an NPV of zero
• The IRR is used to assess the total return from an investment opportunity making some assumptions regarding rental growth, re-letting and exit assumptions
• If the valuer does not have a software programme to calculate the IRR, then linear interpolation can be used to estimate the IRR

Question 5

How do you calculate IRR?

Answer 5

• Input current market value as a negative cash flow
• Input projected rents over holding period as a positive value
• Input projected exit value at the end of the term assumed as a positive
• Discount rate (IRR) is the rate chosen which provides an NPV of zero.