Discounted Cash Flow (DCF) analysis recognises that the future cash flow benefits of any strategy incur upfront investment including incremental operational and financing costs. The method recognises the time value of money based on the following rules;
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A dollar earned today is worth more than a dollar earned tomorrow due to the inherent cost of the opportunity missed of investing a dollar today;
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A distant dollar (a dollar earned tomorrow) is always riskier than a dollar in your hand today, as the future is always risky and uncertain;
The first step therefore is to make an estimate of the projects Cost of Capital (also called the 'WACC' or weighted average cost of capital). This is the cost of raising money to finance a particular strategy taking into account the firm’s unique risk, the market risk and the capital structure of the firm (the weightage of debt and equity).
The next step is to Discount the Cash flows (See DCF above) by actually reducing these future cash flow projections, to adjust the ‘time value’ of money and the risk of earning cash flows at a future date, the principle being the longer the time to earn a particular net cash return on an investment, the greater the reduction in value over the time horizon of the project;
Key benefits of using strategic plans and their accompanying DCF financial plans are:
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They look at the environment in which the firm operates in over the long term taking into account the impact of macro changes in the environment and industry and the internal environment of the firm;
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They re-evaluate the long term strategic position of the firm;
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They account and make adjustments to the cash flows of the firm adjusting them for risk, opportunity costs and the time value of money;
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This allows the firm to make intelligent decisions on which project(s) and selected processes are likely to maximise wealth. Alternatively firms quickly realise that a project that is critical to its survival may not provide a return that creates wealth, prompting managers to re-engineer their approach until they do;
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They eventually provide a measure of the value of the firm. The value of a firm is the sum of the strategic plans of all its projects and the terminal value of the firm.
