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In this section we're going to look at discounted cash flow analysis in more detail by analyzing the formula we can understand what drives the discounted cash flow analysis and how to build it in Excel for more detail on this I suggest taking our financial modeling courses specifically our fundamentals of financial modeling and building a financial model in Excel course outline in great detail how to build a DCF model from scratch if we look at an example of a cash flow that occurs in 2018 we have a discount factor and the formula for the discount factor is one over one plus the rate which is in this case 10 the number of periods in this case 1 the second cash flow which occurs in 2019 is also 100, but this time is raised to the power of 2 as you can see at the bottom here the present value of that number of the 100 is being reduced over time in 2020 it's raised to the power of 3 and becomes only 75 of present value today from 100 of free cash flow in the future by 2021 it's worth 68 today 2022 it's down to 62 and then finally in a DCF analysis we have a terminal value, so the first five years were our forecast a detailed forecast of what we expect cash flow to be over five years, and then we value the business into perpetuity using a terminal value in this case we're saying the terminal value of the business is 300 in future cash flow but raised to the power of five that's only worth 186 dollars today so as you can see the discounted cash flow amount becomes quite big at the end, but the present value is significantly less so to calculate the entire value of this firm which is 565 we add up these cash flows in their present value, so 565 million dollars of present value compared to 800 million dollars of future value now let's take a look at the cost of capital formula the cost of capital depends on the capital structure of a business and its level of risk, so a company consists of assets that's the base of the business, but then it has a capital structure that make up those assets consisting of debt and equity, so we have to take into consideration the percentage of the company's capital that's debt and the percentage that's equity we multiply each of those by their respective costs, and we arrive at the contribution to the cost of capital of each so to sum them up gives us the total cost of capital now let's use a real example with some numbers take a company with the following capital structure debt is on the top equity is on the bottom the proportionate weightings are 14 debt 86 equity the cost of debt after tax is three and a half percent the cost of equity is nine percent this company has a weighted average cost of capital of 82 percent this number is the number that plugs in to the formula we were using on the previous section where we were calculating the present value of a business so in this case instead of being 11 as in the previous example it would be 10 8 2 raised to the power of whatever year or period we're discounting from...
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