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Discounted Cash-Flow Analysis
In the discounted cash-flow (DCF) analysis, the present
value of a company’s projected annual cash-flows over the
forecast period is added to the present value of a company’s
residual value and the value of a company’s nonoperating assets
to arrive at the present value of a company. A DCF analysis
contains an inherent difficulty when used for a company that has
a significant residual value because to determine the present
value of a company, the DCF analysis requires an estimate of what
a company will be worth at the end of the forecast period
(residual value). PCAB’s estimated residual value was neither
minimal nor easily calculated. The BVS report assumes that in 10
years PCAB will be worth 12.5 times net earnings.
In closely held small companies, the use of a DCF analysis
is also suspect when the discount rate is calculated by a
weighted average cost of capital (WACC) determination. Such
determinations often include a determination of the cost of
capital using the “capital asset pricing model” (CAPM). This
Court has recently observed:
We do not believe that CAPM and WACC are the
proper analytical tools to value a small, closely held
corporation with little possibility of going public.
CAPM is a financial model intended to explain the
behavior of publicly traded securities that has been
subjected to empirical validation using only historical
data of the two largest U.S. stock markets. * * *
[Furman v. Commissioner, T.C. Memo. 1998-157.]
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