WFU Law School
Law & Valuation
4.1.3 Discounted Cash Flow (DCF) Model

Desmond DCF Example

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

©2003 Professor Alan R. Palmiter

This page was last updated on: March 30, 2004