Final answer:
The DCF approach in finance is used to value an investment by projecting future cash flows. It adjusts normalized operating earnings by considering interest, taxes, depreciation/amortization, and capital expenditures. The DCF method compares present costs to the present discounted value of future benefits.
Step-by-step explanation:
The Discounted Cash Flow (DCF) approach is a method used in finance to determine the value of an investment, based on projections of its future cash flows. Starting with normalized operating earnings before tax, the DCF method adjusts these earnings by:
- Subtracting interest expense
- Adding back amortization/depreciation expense
- Deducting taxes on earnings to calculate after-tax income
- Subtracting sustaining capital expenditures, net of their associated tax shield
Calculating the after-tax income involves taking the national income and subtracting taxes, as in the example provided. Corporate profits after tax are adjusted for factors like inventory and capital consumption. The present discounted value of these adjusted profits is then calculated by comparing the present costs of making an investment to the present discounted value of future benefits. Understanding the effective tax rate and the annual budget deficit or surplus, which is the difference between tax revenue collected and spending, is also essential in employing the DCF approach.