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Valuation of an under-construction commercial project by Discounted Cash Flow (DCF)

By September 24, 2022June 17th, 2024Case Studies5 min read
Valuation of an under-construction commercial project by Discounted Cash Flow (DCF)

Introduction

A reputed real estate developer company in India was found to be an NPA. The entire asset list of company includes

  • Couple of completed residential and commercial towers with amount receivables from sold unit holders and some unsold units.
  • An under-construction commercial project and development rights of a particular land parcel with existing/occupied tenants over the same
  • Another vacant land.

Situation

  • The reconciliation of amount receivables from sold unit holders doesn’t match with the agreement value and amount received from them.
  • The reconciliation of sold/unsold inventories doesn’t match with the total number of units.

Question Arise

How to arrive at the value of under-construction project without sufficient data by Discounted Cash Flow?

How to arrive at the value of completed project with unsold units and non-reconciled list of receivables from sold unit holders?

What Is Discounted Cash Flow (DCF)?

Discounted cash flow (DCF) is a valuation method which helps to estimate the value of an investment using its expected future cash flows. it attempts to determine the value of an investment today, based on projections of how much money that investment will generate in the future. It can help those considering whether to acquire a company or buy securities make their decisions. Discounted cash flow analysis can also assist business owners and managers in making capital budgeting or operating expenditures decisions.

Why Discounted Cash Flow (DCF) and How Does Discounted Cash Flow (DCF) Work?

The purpose of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money. The time value of money assumes that a particular amount that you have today is worth more than it that you receive tomorrow because it can be invested. As such, a DCF analysis is useful in any situation where a person is paying money in the present with expectations of receiving more money in the future.

Discounted cash flow analysis finds the present value of expected future cash flows using a discount rate. Investors can use the concept of the present value of money to determine whether the future cash flows of an investment or project are greater than the value of the initial investment.
If the DCF value calculated is higher than the current cost of the investment, the opportunity should be considered. If the calculated value is lower than the cost, then it may not be a good opportunity. Or, more research and analysis may be needed before moving forward with it.

To conduct a DCF analysis, an investor must make estimates about future cash flows and the ending value of the investment, equipment, or other assets.
The investor must also determine an appropriate discount rate for the DCF model, which will vary depending on the project or investment under consideration. Factors such as the company or investor’s risk profile and the conditions of the capital markets can affect the discount rate chosen.

If the investor cannot estimate future cash flows, or the project is very complex, DCF will not have much value and alternative models should be employed.

Advantages

  • Discounted cash flow analysis can provide investors and companies with an idea of whether a proposed investment is worthwhile.
  • It is analysis that can be applied to a variety of investments and capital projects where future cash flows can be reasonably estimated.
  • Its projections can be tweaked to provide different results for various what if scenarios. This can help users account for different projections that might be possible.

Disadvantages

The major limitation of discounted cash flow analysis is that it involves estimates, not actual figures. So, the result of DCF is also an estimate. That means that for DCF to be useful, individual investors and companies must estimate a discount rate and cash flows correctly.

Furthermore, future cash flows rely on a variety of factors, such as market demand, the status of the economy, technology, competition, and unforeseen threats or opportunities. These can’t be quantified exactly. Investors must understand this inherent drawback for their decision-making.

DCF shouldn’t necessarily be relied on exclusively even if solid estimates can be made. Companies and investors should consider other, known factors as well when sizing up an investment opportunity. In addition, comparable company analysis and precedent transactions are two other, common valuation methods that might be used.

Answers written down

After several discussion held internally, we managed to conduct the exercise and provide the value of the projects and we also ensured that the projects are neither overvalued nor undervalued. We answered to the question arouse by us:

  • We included only receivables from sale of unsold units at current market rate and future projections under Inflows in Discounted Cash Flow as we do not have any clarity on amount receivables from sold unit holders.
  • We included only construction cost for balance unconstructed area based on actual site observations and sales and marketing charges for sale of unsold units under Outflows in Discounted Cash Flow.
  • We deducted amount already received from sold unit holders from Net Cash Positions in Discounted Cash Flow as the reconciliation of amount receivables was not matching with the agreement value and amount received from them but amount received from sold unit holders was more appropriate to arrive at the valuation of project.

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