Capital Asset Pricing Mode - Discounted Cash Flow

Abstract

In order for a company or individual to be financially successful it must be able to identify potential risks and have a plan to account for and overcome those risks, if they do in fact occur. Identifying risks allows the person or company to fully understand the investment and its overall opportunity. It must also be able to identify the value of itself or assets, and what the potential return of these can be. Having awareness of potential risks will benefit the company and allow greater protection of assets, as well as stability and opportunity for an expected return or even greater. Two models allowing companies and investors that were formulated to allow this is Discounted Cash Flow (DCF) and the Capital Asset Pricing Model (CAPM). Discounted cash flow provides the potential investor with a method to estimate the overall potential that the investment opportunity may hold (Money Chimp). Capital asset pricing model; however, is used to determine the required returns of the investments or assets (Money Chimp).

In the world of finance and accounting discounted cash flow (DCF) analysis is a frequently used process for determining the value of a company, a project, or an asset using the models of time value of money. With DCF all future cash flows are first valued, and then reduced to produce their present values (PV). The first step of DCF is the projection of free cash flow over a specific period of time. iBanking states that free cash flow equals EBIT less taxes plus D&A less capital expenditures less the change in working capital (iBanking FAQ). The second step is predicting the value of the company or assets for the years following the projection period (iBanking FAQ). This can also be referred to as terminal value (iBanking FAQ). The Gordon Growth Method (Perpetuity Growth) and the Terminal Multiple Method are the two methods that can be used for calculating terminal value, according to iBanking FAQ (iBanking FAQ). A brief explanation of the Gordon Growth given by iBanking FAQ states that first a modest and appropriate rate where the company can grow and advance forever must be chosen (iBanking FAQ). The calculation of terminal value using this method is to multiply the final year's free cash flow by 1 plus the chosen growth rate. Then it must be divided by discount rate less the growth rate (iBanking FAQ). The terminal multiple method is more frequently used in banking. iBanking says that the company must take an operating metric for the final projected year and then multiply by an applicable valuation multiple. These methods make it possible to determine a discounted cash flow analysis.

The Capital Asset Pricing Model (CAPM) is used in order to calculate investment risk, and what the expected investment return should be (McClure). The model perceived that individual investments contain both systematic risk

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