280 ENTREPRENEURSHIP
they are out of business. An earnings model may depict the business as healthy even
when it cannot pay its bills or open its doors to customers. A cash-based model is more
sensitive.
Another advantage of the cash model is that it includes cash flow that can be ap-
propriated by the founder/owner and the top management team. Cash payments to the
entrepreneurs—e.g., contributions to Keogh plans and other retirement schemes, re-
turns from debt repayments, interest payments, salaries, tax shields and advantages, div-
idends, and cash replacement perquisites like automobile insurance—can all be included
in calculating the value of the firm to its owners. When a firm is owned by hundreds of
thousands of small shareholders, these items are irrelevant. (Indeed, they decrease the
firm’s value to stockholders.) For a closely held firm, however, they are quite relevant.Disadvantages of DCF Valuation. One of the most important disadvantages of the
DCF model is that it was originally used for capital budgeting to provide a reliable
ordering of alternatives. Entrepreneurs are not usually evaluating a range of options
They are focused on this one venture so the benefit of reliable ordering is lost. If the
other essential numeric inputs into the DCF calculation are also unreliable, the valuation
will be a prime example of “garbage in, garbage out.”
A second problem arises from estimating the numerical inputs into the DCF equa-
tion. Three major inputs include an estimate of the period of the cash flow (usually
annual), the estimate of the weighted cost of capital (discount rate), and the estimate of
the terminal (or horizon) value of the firm. If these calculations are off, the valuation
will be wide of the mark.Discounted Cash Flow Example. To calculate the value of the firm with the DCF
model, the following equation is used:
V = C 0 + C 1 /(1 + k) + C 2 /(1 + k)
2
+ C 3 /(1 + k)
3
+ Cn/(1 + k)
n
=? Ct/(1 + k)
t
Where:V is the value of the firm.
C is the cash flow in each period t.
k is the firm’s cost of capital.For example, suppose the entrepreneur projected that a business could be started for
$1 million and generate the cash flows listed in the following table. If an entrepre-
neur has a weighted cost of capital of 15 percent and the firm’s capitalization rate is
.20, its terminal value, or TV, then is $1,000,000/.20 = $5,000,000, and the value
of the venture is $3,557,720.
Cash Flows in $000
Yr. 0 Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5 TV 5
1,000 200 400 800 1,000 1,000 5,000
Method: discount these flows by (1 + k)n