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## Topic: Capital Asset Pricing Model Discounted Cash Flow Analysis

The capital asset pricing model and the discounted cash flow analysis are both used in determining the performance of stocks. Usually, the discounted cash flow analysis discounts all probable future cash inflows of an organization, to obtain the present value of the firm. Therefore, the use of the discounted cash flow helps an investor to assess the attractiveness of an investment. When estimating the attractiveness of a broad portfolio, an investor normally uses the weighted average cost of capital.

The capital asset pricing model (CAPM), establishes the minimum required return (expected return) of a stock, which is related to its systematic risk. Accordingly, the knowledge of the discounted cash flow analysis (DCF) and the capital asset pricing model (CAPM) will help in determining the suitability of the inherited portfolio.

## Discounted Cash Flow Analysis

The discounted cash flow (DCF) estimates the attractiveness of an investment. Usually, the future free cash flows from an investment are discounted to predict their present value. In cases where an organization has a portfolio made of many stocks, a weighted average cost of capital is used to estimate the potential of the entire portfolio (Render et al. 71-76).

The determination of whether an investment is attractive or not depends on the present value of its future cash flows as compared to the current cost of the investment. In this case, an investment is attractive if the present value of the future cash flows is more than its current value. Similarly, an investment is not attractive if its present value of future cash flows is lower than its net costs.
Discounted cash flows are calculated as follows:
PV= CF1/(1+k) +CF2/ (1+k)2 +…[TCF/(k-g)]/(1+k) n-1
Where
PV= present value
CFi= Cash flow in year i
k= discount rate
TCF= Terminal year cash flow
G= growth rate assumption in perpetuity beyond terminal year
N= Number of the year in the valuation model including the terminal year (Render et al. 84).
There are usually many variations made when determining the future cash flows and discount rates in the discounted cash flow analysis.

Typically, there can be the consideration of depreciation, operating profits, amortization of goodwill, capital expenditures, cash taxes, and changes in the working capital when establishing a firm’s cash flows. Overall, an analyst considers the amount of money received from a project/ stocks and discounts them to establish their present value.

## Determination of When to Buy, Sell, Hold

When to buy, sell, or hold strictly depends on the value of the future cash flow of the investment. In this case, stocks/investments whose present value of future cash flows is greater than their net investment costs should be bought.

An investor can hold those whose present value of their future cash flows are more to their current cost. Finally, an investor should sell stocks whose present value of the future cash flow is lower than their current value (Render et al. 96).

## Capital Asset Pricing Model

Essentially, the capital asset pricing model (CAPM) measures the expected return of a stock. In a well-diversified portfolio, CAPM helps an investor to establish the possible return on his/her investment. Therefore, CAPM gives a relationship between the expected return on an investment and its systematic risk (Patrick). Accordingly, the expected risk of a stock/ investment is calculated as follow:
E(r)= R(f) + β(a)(R(m)-R(f))
Where
E(r)= Expected risk
R(f)= Risk-free rate
β(a)= Beta of asset
R(m)= Expected market return on asset (Patrick)
CAPM is founded on the assumption that investors are rational, and they weigh risks when making investments.

Therefore, they should be equally compensated for risk undertaken and their time value of money. The product of the assets beta and that of the market return less the risk-free rate {β(a)(R(m)-R(f))} represents the risk premium, which shows the additional income that shareholders aim at making from their investment (Patrick). Noteworthy, any smart investor should only invest in assets that have a higher return than the risk-free rate.