DCF Valuation with Cash Flow Cessation Risk
Journal of Applied Finance, Spring/Summer 2012, Volume 22, Issue 1, pp. 175-185
Posted: 29 Jul 2012
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DCF Valuation with Cash Flow Cessation Risk
Date Written: 2012
Abstract
The typical discounted cash flow model used to value assets openly projects cash flows for an initial set of years and then typically assumes that the cash flows will grow at a constant rate into the indefinite future. In this paper, we discuss the implications for valuation and the discount rate when one assumes that cash flows have a non-zero probability of cessation throughout the valuation period. We demonstrate that, if one allows for even a small cessation probability, then a substantially higher discount rate is required in deriving the present value of the expected stream of cash flows.
Keywords: Discounted Cash Flow (DCF) model, valuation, discount rate, probability of cessation
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