The Value Of Cash Flow

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a) Discounted Cash Flow (DCF) valuations aims to establish the value of operating business on a ’cash free/debt free’ basis and therefore it is normally undertaken using ungeared cash flows. The value of the business should remain the same regardless of its financial structure.
In case that geared cash flow is used in an equity model valuation, it should be discounted at the cost of equity capital and not a weighted average cost of capital (WACC). This approach estimates the shareholders’ net returns after tax and debt servicing.
The other reason why incorporating the interest payments is inappropriate is due to the fact that it leads to double counting the time value of money. This mistake is often realised by discounting positive the positive cash flow in one year and then incorporating interest on the same cash flow in income in the following year.

b) Strengths
• DCF valuation can provide an estimate of intrinsic value of the business by capturing its underlying fundamentals including WACC, cost of equity and growth rate. The intrinsic value of the business provides an estimate of present value of cash flows that the company will pay its shareholders and therefore it should help investors to identify companies that are inexpensive compared to its peers.
• DCF relies on free cash flows which provide a reliable measure that mitigates the subjective accounting practices and often inaccurate estimates of reported earnings. Irrespective of how cash outlays are
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