A seven-year DCF forecasts operating income growing 3% annually and a terminal sale at the end of year 7. One 7.2% discount rate applies to every benefit. Which receipts in the seven-year model are discounted?
Correct Answer
C) All operating cash flows and sale proceeds, each when received.
In a single-rate DCF, discount each dated interim benefit and the terminal proceeds at the stated discount rate. Growth changes cash-flow amounts, not the discount rate. Differentiated supported rates for differently risky components are not universally prohibited.
Why This Is the Correct Answer
Option C is correct because in DCF analysis the forecast set of cash flows, including the reversionary cash flow, is discounted at the given discount rate. Each year-end operating cash flow and the year 7 terminal proceeds are discounted for their own number of periods at 7.2%. The 3% growth rate only changes the amounts being discounted.
Why the Other Options Are Wrong
Option A: The terminal sale proceeds, but not the interim income.
Option A, discounting the terminal sale proceeds but not the interim income, is wrong because income received in years 1 through 7 also arrives in the future. Each interim cash flow must be discounted to present value along with the reversion.
Option B: The year 7 operating income, but not earlier years.
Option B, discounting only year 7 operating income and not earlier years, ignores that income in years 1 through 6 also has a time value. Each forecast year's income, plus the terminal proceeds, is discounted at its stated time.
Option D: Operating income at the 3% growth rate instead of the discount rate.
Option D, discounting operating income at the 3% growth rate instead of the discount rate, confuses two different inputs. Growth determines how large each year's income is, while the specified 7.2% rate is what converts those amounts to present value.
Each dollar, its own date
In a DCF, each forecast dollar is discounted back from the date it arrives, whether it is annual income or sale proceeds.
How to use: Use this to decide which cash flows in a DCF must be discounted.
Exam Tip
Keep growth rates and discount rates separate: growth builds the cash flow forecast, and the discount rate converts it to present value.
Common Mistakes to Avoid
- -Discounting only the reversion and adding interim income at face value
- -Using the income growth rate as the discount rate
- -Discounting every cash flow for the full holding period regardless of when it arrives
Concept Deep Dive
Analysis
This question tests what gets discounted in a discounted cash flow analysis. Each forecast benefit, both the annual operating cash flows and the reversion, is discounted from its date at the stated rate. Growth affects the size of each cash flow but is not the rate used to discount it.
Background Knowledge
A DCF forecasts income and expenses for each year of a holding period plus a reversion at the end, then discounts each amount to present value. The sum of those present values indicates the value of the interest.
Real-World Application
An appraiser valuing a multi-tenant office building builds a seven-year forecast with rent escalations and a resale at the end of year 7. Each annual cash flow and the net resale proceeds are discounted at the market discount rate and summed.
More Income Approach Questions
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Previous Question
The subject property is an office building with stabilized NOI of $123,000. Typical financing for similar properties is a 75% loan-to-value loan at 6.5% interest with a 7.6% annual mortgage constant. Equity investors expect a 10% equity dividend rate. At the value indicated by the band of investment, what is the annual pre-tax cash flow to equity?
Next Question
A landowner’s leased fee DCF contains ground rent for 40 years and a $3 million reversion at year 40. One 5% annual discount rate applies to both. How is the reversion treated?