The DCF Appraisal Process

To determine the intrinsic value of the project (as well as an alternative means of comparing several different projects, or even several different versions of the same project), the IRR is calculated as that unique discount rate that makes the NPV equal to zero. The IRR cannot be calculated from a single equation, but must be determined iteratively, and the final stage may be graphical. 

The IRR will be the ultimate goal of the DCF process, but it is usually a good idea also to determine the NPV of the project for one of the company rates of return - and the hurdle rate is the most obvious. 

It is unlikely that an IRR of 15% or less will be of much interest to a company, certainly for a new development, while it is also unlikely that a rate of over 35% is feasible, unless it is for a very exotic and expensive product. The discount rates used in appraisal calculations, therefore, usually lie in the 15-35% range. In this range, the DFs for 11 years or more are so large as to make any calculation beyond 10 years rather pointless, so confirming the choice of 10 years as an economic lifetime. 

The basic steps of a DCF appraisal are shown in Table 4, which describes a project whose total capital employment is 124 million, spent as shown over a 3-year construction period (including expenditure at year 0, i.e. the point of start-up). Revenues rise during the first 2 years of operation to a maximum figure from year 3 onwards. 

The project takes three years to build, numbered —3, —2, and —1 respectively. 

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