Example
How did the Desmond court
apply DCF? After settling on the expected cash
flows and the appropriate discount rate, the
Tax Court applied the DCF model, also known
as the "income" method.
First, the court calculated the
present value for each of the first five years
and summed the results. Second, the court calculated
the terminal value of the company
by determining the value of the perpetuity beginning
after the fifth year ($1,740,000 per year after
1997). This figure was then discounted to present
value. Third, the two present value figures
were added together to reach the estimated value
of the company.
Year |
Discount rate |
Cash flow
($000s) |
Present value
formula |
Present value |
1992 |
19% |
1,162 |
= 1,162/(1+.19)1 |
976 |
1993 |
19% |
1,290 |
= 1,290/(1+.19)2 |
911 |
1994 |
19% |
1,432 |
= 1,432/(1+.19)3 |
850 |
1995 |
19% |
1,589 |
= 1,589/(1+.19)4 |
792 |
1996 |
19% |
1,764 |
= 1,764/(1+.19)5 |
739 |
1997 and thereafter |
19% |
9,159 |
= 9,159/(1+.19)5 |
3,838 |
| |
|
|
Total Present
Value |
$8,107 |
In the words of the court:
[The executor's expert] determined the value
under the income method was $8,109,000. Under
this method, [the expert] determined the present
value of Deft's future cash flows for the
5 years following the valuation date ($4,271,000)
and the present value of a terminal value
computed for the fifth year ($3,838,000) using
a 19-percent discount rate. [The expert] added
these present values together to find the
value under this method. ***We find [the expert's]
conclusions as to the values under this method
reasonable, and we conclude that the unadjusted
value under the income method is $8,109,000...
Note: The difference
in calculations above and the court opinion is
because of rounding. |
4.1.3 Discounted Cash Flow (DCF) Model