DCF

Discounted Cash Flow

Discounted Cash Flow

Question 1 (A)

Explain the nature of, and rationale for using, discounted cash flow (DCF) techniques in property decisions with long-term consequences.

Discounted Cash Flow (DCF) is an effective investment appraisal tool for most kinds of long term investments and projects. In the past, financial appraisal was usually done through methods like Accounting Rate of Return (ARR) and Payback Period. The traditional methods failed to account for the uncertainties and risks associated with losses in the Time Value of Money. Hence, projects whose life spanned over a long period like property and construction were subjected to financial failures. DCF analysis properly forms the basis for all capital budgeting techniques as it takes account of the life and the timing of cash flows (Adair 2005, p.259). The capital budgeting technique applied should ensure the proposals are profitable enough for comparison. The selected alternative yields the highest rates or return not lower than the minimum acceptable rate or return, and allows all proposals to be ranked according to profitability.

DCF analysis includes more variables and data inputs than traditional financial analyses. In the main DCF is used as an appraisal tool to determine whether the price for the property in the market fairly reflects its worth from the investor's perspective (Pratt et al 2000, p.45). Thus, these inputs are viewed from the investor's perspective, not that or the market place.

DCF analysis requires the property analyst to:

• reflect the components of all anticipated cash flows:

• have cash flows based on comparables and reasoned forecasts:

• reflect investors' market perception:

• reflect debt finance:

• reflect Taxes: and

• reflect risk to future net incomes and capital flows.

Discounted cash flow calculations can arrive at a single figure or a range of figures for worth by reflecting all anticipated cash flows, based on analysis or comparables or indirect evidence and expectations or the future derived from forecasts or estimates. In contrast, the inputs to valuations are derived from current market evidence, and there is no forecasting of rents. In a valuation, if there is a rent review in say three years' time, it is current rental value that is applied as at the rent review date and not forecast rental value. This is because any rental growth is implied into the valuation yield (Ball 2004, p. 54). Implicit within the valuation yield are all the factors influencing the property and its returns in the future. The valuation yield used in the valuation is derived from evidence of comparable deals done. Cash flows

Throughout the holding period, the cash flow must be estimated: this requires knowledge or actual cash flows and estimation of future cash flows which will be based on estimates or rental growth: potential voids: and depreciation and estimates or outgoings (such as refurbishment costs). Or particular importance is the terminal value and the exit yield used to arrive at the exit value (Maki & Lichty 2000, p. 80). At the end of the holding period, the ...