Pitfalls of Discounted Cash Flow Analysis

Correctly appraising capital projects with DCF analysis methods requires knowledge, practice and acute awareness of potentially serious pitfalls. I want to point out some important errors in project appraisal and suggest ways to avoid them. For many people DCF analysis seems to be quite easy, but it can be very difficult for complex projects. Here are some crucial issues from my point of view:

  • Decision focus: The calculation is focused on making the right decision concerning a project or an investment. That can be different from a calculation including all expenditures of the project or investment, e.g. sunk costs. For further comments concering this topic see Incremental Free Cash Flows.
  • Point of view: It has to be defined clearly from which perspective you are doing the decision and calculation. For example, the calculation can be different from the view of a business area and from the view of the overall company. The right perspective to the decision problem determines the relevant incremental cash flows.
  • Investment: Define clearly what you mean when talking about “investment”. Avoid the balance sheet view, look at investment as initial expenditures required for later contribution cash flows. In my point of view the term “investment” is best defined as commitments of resources made in the hope of realizing benefits that are expected to occur over a reasonably long period of time in the future.
  • Cash flows: A clear view of cash flow is important, avoid views from accounting and cost accounting, e.g. depreciation. And take into account tax effects.
  • Incremental cash flows: The correct definition of incremental cash flow is crucial. It is the difference between the relevant expected after-tax cash flows associated with two mutually exclusive scenarios: (1) the project goes ahead, and (2) the project does not go ahead (zero scenario). Sunk costs must not considered. For further comments see Incremental Free Cash Flows.
  • Comparing scenarios: Alway be aware of having a relative sight between the cash flow scenarios. Sometimes it is not so easy to define what would happen in the future without the project (zero scenario).
  • Risk-adjusted discount rates: Risk adjustment of discount rates has to be done for all (!) cash flows of the investment project that have significant risk differences: Fixed costs, investment expenses, one time expenses and payments, expenses for working capital, leasing, tax shields and contribution cash flows (turnover and variable costs) in various markets. For more infos concerning risk adjusted discount rates see Component Cash Flow Procedure.
  • Key figures: The only key figure that is valid for all types of projects and investment decision is the famous NPV. All other well-known figures like IRR, Baldwin rate, … are leading to false decisions in some cases. NPV also allows to build the bridge to financial calculation approaches like option valuation. Payback and liquidity requirements have to be considered carefully additionally to NPV.
  • Expected versus most likely cash flows: Quite often analysts take most likely cash flows. The right way is to consider the expected value (mathematical definition) of the cash flows.
  • Limited capacity: Do not forget internal capacity limitation when regarding market figures. Limited capacity has also to be considered when constructing the event tree in real options analysis. Besides that the temporal project value development with contribution cash flow’s discount rate has to be ensured in the binomial tree.
  • Hurlde rates: Avoid hurlde rates for project decisions, because the can also lead to false decisions. Especially when you take one hurdle rate for different projects.
  • Cash flow forecasting: Forecasts are often untruthful. Try to verify and countermeasure cash flows from different sources.
  • Inflation: Be careful considering inflation. In multinational project it might influence the foreign currency location’s required return. You can also consider a relationship between inflation rate and expected future exchange rates according to the purchasing power parity (PPP).
  • Real and nominal discount rates and cash flows: The procedure should be consistent for cash flows and discount rates. Usually we take nominal values for the calculation.
  • Real options: A DCF analysis should always be linked to a real options analysis. The more flexibility is in the project the more important is a real options analysis. Risk adds value to real options.
  • Precise cash flow timing: The influence of timing intervals can be significant. You can choose smaller time intervals in crucial time periods to increase accuracy.
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