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Discounted Cash Flow Method

The Discounted Cash Flow Method involves estimating net cash flows over the period of investment (Holding Period), and then calculating the present value of that series of cash flows by discounting those net cash flows using a selected "discount rate."  Conversely, if the discount rate is unknown, but the initial investment is known, we can calculate the discount rate.

We will discuss the basic information necessary to perform a Discounted Cash Flow Analysis, both when financing is involved in the transaction and when it is not. We also refer you to the discussion of the Mortgage Equity Technique. You will see that Discount Cash Flow Analysis and the Mortgage Equity Techique are "flip" sides of the same coin.

Both Commercial Complete and Investment Analyst have extensive discounted cash flow capabilities and both utilize the Mortgage Equity Technique.

Components of a Discounted Cash Flow Analysis

Estimating Net Cash Flows

Estimating net cash flows produced by an investment means projecting all payments (cash outflows) by the investor and all (cash receipts) income that the investor receives.  The timing of these cash flows is important to the analysis.  Commercial Complete and Investment Analyst require that cash flows be estimated on an annual basis.

Cash outflows by the investor include:

  • Initial investment, including loan points and other fees.
  • Expenses associated with the investment.
  • Other cash outflows, such as principal payments to a lender.
  • Selling expenses upon liquidation of the investment.


Cash Receipts Include:

  • Annual income from the investment.
  • Net proceeds upon liquidation (after loans are repaid)

Discount Rate

In the context of our discussion here, the discount rate is analogous to the investor's Required Before Tax IRR, or the rate of return on the investor's equity investment. This rate can be compared to the yields of other market instruments like Treasury Bonds, Corporate Bonds, and savings accounts.



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Initial Cash Investment

The initial cash investment is the amount that the investor must pay the seller for the right to receive future cash flows from the investment.  It includes loan points and fees, and sometimes improvements and repairs to the property that cannot be financed.

A Simple Discounted Cash Flow Analysis - Finding the Present Value of an Investment

Assume that the investor acquires an investment for cash, and that he requires a 10% yield on his investment each year.  Further assume that he will hold the investment for one year.  What should he pay to acquire the investment?

The following statements are analogous:

  • The investor wants to receive a 10% yield on his investment each year.
  • The investor wants the annual rate of return on his investment to equal 10%.
  • The investor wants the Annual Percentage Rate on his investment to equal 10%.
  • The investor wants the Internal Rate of Return on his investment to equal 10%.
  • The investor's discount rate is 10%.

To find the amount that he should pay (the present value), the investor estimates the cash flows to be received over the holding period, and then he "discounts" these cash flows using the 10% discount rate.  We will assume a net income of $10,000.00.

Calculation of Net Cash Flows

Net Income $10,000
Reversion (sale of investment) $100,000
Total Cash Flow $110,000


Discounting the Net Cash Flows

To discount the net cash flows shown above, we first calculate the "discount factor," based upon our discount rate of 10%.
The formula for calculating this factor:

1 / (1+discount rate) ^ period = discount factor
or
1 / (1.10) ^ 1 = .909090909

where the discount rate is 10% and period equals 1

Multiplying this one year discount factor by the net cash flow results in a present value for the investment of $100,000.00.

Net Cash Flow Present Value Discount Factor Value
$110,000 divided by .909090909 equals $100,000

The goal of a discounted cash flow analysis is to determine what value (there is only one) will produce the cash flows that satisfy the market criteria set out in the analysis. With regards to real estate, these market criteria often involve a mortgage loan. The Net Cash Flow example above of $110,000 is also often referred to as "Net Income". Since there is no loan involved in our example, Net Cash Flow and Net Income are synonomous. But if a mortgage loan is a part of the transaction, Net Income and Net Cash Flow are NOT synonomous. In a Discounted Cash Flow Analysis, we always must discount the Net Cash Flow, not the Net Income.

Below, we provide an example of a Discounted Cash Flow Analysis when a loan is involved.


Discounted Cash Flow Analysis - with a Mortgage Loan

In the example above, we knew the Net Cash Flows and we knew the discount rate.  But in more complex analyses, net cash flows are dependent upon the initial cost of the investment.  If, for example, some of the funds will be borrowed, the loan amount and the repayments of that loan will be dependent upon the initial cost of the investment.  Thus, to project the net cash flows, we must first establish the cost of the investment.  When we do this, the unknown becomes the discount rate or Internal Rate of Return (these two terms are synonymous as used here), and our problem becomes finding the Internal Rate of Return that will satisfy the investor's requirements and also cover the mortgage loan payments.

To illustrate, assume that a particular investment will be acquired, using 50% borrowed funds and 50% cash equity; and further that the purchase price is $90,909.10 (this odd purchase price will facilitate our example).  The cost of the borrowed money is 12%, payments are interest only, and the holding period for the investment is one year.

The process of finding the Internal Rate of Return is called interation; i.e. we must find a discount rate (or IRR) to apply to the net cash flows whose result is equal to the present value of the initial cash investment (already known).  This is a trial and error method that would take considerable time if done by hand.  Fortunately, the computer is able to make these calculations very quickly.  The result is shown below.


Calculation of Net Cash Flow

Sale proceeds upon liquidation $90,909.10
Net Income $10,000
Interest Paid (90,909.10 / 2 x .12 -5,454.55
Loan repayment -45,454.55
Net Cash Flow $50,000

Calculation of the Present Value Discount Factor for one year at 10%

1/(1+discount rate) ^ period = Discount Factor
1/(1.10) ^ 1 equals .9090909


Present Value of Net Cash Flows

Net Cash Flow Present Value Discount Factor
APR
IRR
Equity Yield Rate
Value of Initial Investment
$50,000 divided by .909090909 equals $45,454.55


As you can see, using an IRR (or discount rate) of 10%, the present value of the net cash flows is equal to the initial investment of $45,454.55.  The present value of the initial loan amount must be added to the present value of the initial investment in order to determine the value of the property.

Present Value of Initial Investment $45,454.55
Present Value of Initial Loan $45,454.55
Present value of the Total Property $90,909.10






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