Content area
Full Text
The Discounted Cash Flow (DCF) analysis usually involves long-term asset valuations yet assumptions are made to allow static variables to be introduced into this potential dynamic model. This paper advances pedagogical literature by offering a detailed Excel walkthrough incorporating a Monte Carlo Simulation to account for changes in both the growth rate in free cash flows (FCF) and the cost of capital. The empirical results are startling as projects that 'pass' the NPV acceptance rule, reveal possible negative values or extremely low positive ones that would have gone un-noticed in a traditional DCF analysis and would have resulted in a non-acceptance decision. This paper posits and empirically shows that MCS complements the DCF with results that more closely approximate the 'true' net present value (NPV) by incorporating a set of dynamic variables that directly measure the anticipated cash inflow-outflow valuation relationship.
INTRODUCTION
In the area of valuation, the Discounted Cash Flow (DCF) method is widely viewed as an acceptable means to measure the net present value (NPV) of firms, projects, and securities (Downes and Goodman 1998). In a project valuation, the DCF is dependent upon determining the expected after-tax free cash flows associated with an asset and then discounting these cash inflows and outflows to find the aggregate net present value (NPV) contributing to the decision making process. The model's major components for valuation are the estimated future cash flows and the accompanying cost of capital (Seitz and Ellison 1999). In an academic setting, students use these to arrive at decisions of acceptance/rejection. These involve long-term valuations yet assumptions are made to allow static variables to be introduced into a potential dynamic model. This paper addresses the issue that the DCF is conducted under uncertainty and as such, the estimated future cash flows need to reflect deviations over the time horizon. A Monte Carlo Simulation (MCS) is utilized to account for changes in both the growth rate (g) in the free cash flows (FCF) and the cost of capital (k) of the asset. While 'canned' programs exist for the MCS, this paper advances the pedagogical literature by offering a detailed walkthrough of creating a DCF analysis based on a MCS in an Excel spreadsheet. The latter creates a normal distribution of at least...