CHAPTER 6Discounted Cash Flow Method

John Jackmanand Antonella Puca

The discounted cash flow (DCF) method is an income-based approach in which enterprise value is estimated based on the present value of the company's expected cash flows, discounted at a rate that reflects the risk of these cash flows. The credibility of the DCF method lies in a reliable cash flow forecast and well-developed discount rates. The estimate of a discount rate that considers both the prospective of the firm in acquiring its capital resources (cost of capital) and of market participants in pursuing their risk/return objectives (rate of return) is an important step in ensuring that a DCF model for an early stage enterprise (ESE) is reasonable and consistent with fair value principles.

This chapter develops a DCF model to estimate enterprise value under the fair value standards of ASC 820/IFRS 13, using a venture-backed ESE as an example. After presenting the model's components and key assumptions in some detail, the chapter shows how a DCF model can be built to reflect the special characteristics of an ESE using a scenario analysis to account for the company's risk of failure. We then discuss how a DCF model can be calibrated to estimate the fair value of the enterprise in subsequent measurement.1 As we walk through our model, we highlight some key considerations concerning the valuation process and the documentation requirements under the Mandatory Performance Framework (MPF).2

In his studies of early ...

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