Cost of Capital Using Discounted Cash Flow Approach

In finance, the discounted cash flow (DCF) analysis is a method of valuing a project, company or asset using the concepts of time value of money (Wikipedia, 2004). Three inputs are required to use the DCF, also called dividend-yield-plus-growth-rate approach, include: the current stock price, the current dividend, and the marginal investor’s expected dividend growth rate. The stock price and the dividend are east to obtain, but the expected growth rate is difficult to estimate (Ehrhardt & Brigham, 2011). The advantages and disadvantages of using DCF approach will be explained along with the further clarification on the cost of capital using DCF approach. The cost of capital is a term used in the field of financial investment to refer to the cost of a company’s funds, both debt and equity, or from an investors’ point of view, the shareholders required return on a portfolio of a company’s existing securities. It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet (Wikipedia, 2004). In other words, it is the expected return that is required on investments to compensate for the required risk. It represents the discount rate that should be used for capital budgeting calculations. The cost of capital is generally calculated on a weighted average, also called Weighted Average Cost of Capital (WACC). To value of any asset or business is a reflection of the present value of the benefits and liabilities of that asset or business. To use the DCF approach, add the firm’s expected dividend growth rate to its expected dividend yield. See the formula below:
Rs=D1/P0 + Expected g
The discounted cash flow approach represents the net present value of project cash flows available to all providers of capital, net of the cash needed to be invested for generating the projected growth. The concept of DCF valuation is based on the

References: Ehrhardt, M. C., & Brigham, E. F. (2011). Corporate finance: A focused approach (4th ed.). Mason, OH: South-Western Cengage Learning. McClure, B. (2011). Pros and Cons of Discount Cash Flow Analysis. Retrieved on May 25, 2011 from http://www.investopedia.com/university/dcf/dcf5.asp). Macabacus (2011). Discount Cash Flow Analysis. Retrived on May 25, 2011 from http://www.macabacus.com/valuation/DCF/terminal-value.html. Wikipedia: The free encyclopedia. (2004, July 22). FL: Wikimedia Foundation, Inc. Retrieved May 17, 2011, from http://www.wikipedia.org