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This paper focuses on ways in which the discount cash flow approach can be adapted to value forecasted cash flows that are biased measures of expected cash flows.I do this by deriving adjusted discounted cash flow formulas that incorporate the deviations of the forecasted cash flows from the unobservable expected cash flows.I imagine a simple setting in which the forecasted cash flows differ from the unobservable expected cash flows in a well-defined way.Specifically,I assume the expected cash flows equal the forecasted cash flows plus a missing component.Depending on the characterization of the missing component,I get different adjustments to the discount cash flow formula.
The idea of adjusting the discounted cash flow formula for inaccurate forecasts is not novel and those adjustments generally increase the DCF discount rate.Poterba and Summers (1995) show that managers often increase the discount rate beyond market-based cost of capital measures and suggest that one reason for this is to account for optimistic cash flow forecasts.Zenner,Berkovitz and Clark (2009) report that the cash flows used in valuation are typically derived from base-case scenarios that do not include the “possibility of severe downside scenarios.” As a result,the base-case cash flow forecasts are not expected cash flows.They report that “[b]ecause it is challenging to adjust cash flows for downside scenarios,increasing the internal hurdle rate when evaluating new projects is common practice.”
Venture capital firms also use high discount rates when evaluating potential investments.Sahlman (2009) describes the “venture capital method” of valuation in which potential investments are valued by discounting forecasted terminal value,estimated assuming the success of the project,by discount rates that range from 35% to 80%,with the discount rates decreasing as the project successfully advance through its stages of development.Sahlman explores several different explanations for these high discount rates used by venture capitalists,including as an adjustment for the overly optimistic forecasted cash flow that is higher than the expected cash flow,by definition,because it is based on the assumption of a successful outcome.
Similarly,valuations of international projects or firms often include a “country risk premium” as part of the discount rate.The country risk premium is generally not intended as an adjustment for inflation differences which are included elsewhere or for mis-measurement of systematic risk.Instead,as shown by Esty (2002),the country risk premium can be interpreted as an adjustment for over-optimistic forecasted cash flows that ignore downside scenarios related to political risks such as higher taxes and other forms of expropriation.
This paper focuses on ways in which the discount cash flow approach can be adapted to value forecasted cash flows that are biased measures of expected cash flows.I do this by deriving adjusted discounted cash flow formulas that incorporate the deviations of the forecasted cash flows from the unobservable expected cash flows.I imagine a simple setting in which the forecasted cash flows differ from the unobservable expected cash flows in a well-defined way.Specifically,I assume the expected cash flows equal the forecasted cash flows plus a missing component.Depending on the characterization of the missing component,I get different adjustments to the discount cash flow formula.
The idea of adjusting the discounted cash flow formula for inaccurate forecasts is not novel and those adjustments generally increase the DCF discount rate.Poterba and Summers (1995) show that managers often increase the discount rate beyond market-based cost of capital measures and suggest that one reason for this is to account for optimistic cash flow forecasts.Zenner,Berkovitz and Clark (2009) report that the cash flows used in valuation are typically derived from base-case scenarios that do not include the “possibility of severe downside scenarios.” As a result,the base-case cash flow forecasts are not expected cash flows.They report that “[b]ecause it is challenging to adjust cash flows for downside scenarios,increasing the internal hurdle rate when evaluating new projects is common practice.”
Venture capital firms also use high discount rates when evaluating potential investments.Sahlman (2009) describes the “venture capital method” of valuation in which potential investments are valued by discounting forecasted terminal value,estimated assuming the success of the project,by discount rates that range from 35% to 80%,with the discount rates decreasing as the project successfully advance through its stages of development.Sahlman explores several different explanations for these high discount rates used by venture capitalists,including as an adjustment for the overly optimistic forecasted cash flow that is higher than the expected cash flow,by definition,because it is based on the assumption of a successful outcome.
Similarly,valuations of international projects or firms often include a “country risk premium” as part of the discount rate.The country risk premium is generally not intended as an adjustment for inflation differences which are included elsewhere or for mis-measurement of systematic risk.Instead,as shown by Esty (2002),the country risk premium can be interpreted as an adjustment for over-optimistic forecasted cash flows that ignore downside scenarios related to political risks such as higher taxes and other forms of expropriation.
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