Heritage Capital Group, Jacksonville, Florida. There are many conceptual and practical problems inherent in the business valuation of a closely held business using discounted cash flow (DCF). One of the most critical and basic decisions an appraiser has to make is to define the appropriate calculation of cash flow and match it with the appropriate discount rate. If this selection is not made properly, the entire appraisal is invalid, even if every other decision is made correctly. This article describes four choices the appraiser may use as the definition of cash flow, the appropriate discount rate that matches each definition, and the values that result from these choices.
Direct and Indirect Cash Flow Calculation
Appraisers can calculate cash flow using the two general formats that are found in the Generally Accepted Accounting Practices (GAAP) cash flow statement commonly constructed by Certified Public Accountants (CPA’s). The two methods are direct and indirect and it is vital for the appraiser to understand the specific cash flow elements contained in these.
The method illustrated in Exhibit 1 is consistent with the direct method in which cash inflows and cash outflows are directly calculated. The primary source of cash inflow for most businesses is, of course, cash sales and collections. From this point, most of the remaining activities of the business cause cash outflows, such as operating expenses, replacement and growth in assets, and financing outflows associated with debt, payment of preferred and common stock dividends, and repurchase of stock. However, several activities add to the cash flow stream. These include asset liquidations, additional borrowing, and issuing preferred and common stock.