Write a detailed note on discounted cash flows (DCF) valuation method.

Discounted cash flow valuation is based upon expected future cash flows and discount rates. This approach is easiest to use for assets and firms whose cash flows are currently positive and can be estimated with some reliability for future periods. Discounted cash flow valuation, relates the value of an asset to the present value of expected future cash flows on that asset. In this approach, the cash flows are discounted at a risk-adjusted discount rate to arrive at an estimate of value. The discount rate will be a function of the riskiness of the estimated cash flows, with lower rates for safe projects and higher rate for riskier assets. The discounted cash flow (DCF) model is applied in the following steps: Estimate the future cash flows of the target based on the assumption for its post-acquisition management by the bidder over the forecast horizon. Estimate the terminal value of the target at forecast horizon. Estimate the cost of capital appropriate for the target. Discount the estimated cash flows to give a value of the target. Add other cash inflows from sources such as asset disposals or business divestments. Subtract debt and other expenses, such as tax on gains from disposals and divestments, and acquisition costs, to give a value for the equity of the target. Compare the estimated equity value for the target with its pre-acquisition stand-alone value to determine the added value from the acquisition. Decide how much of this added value should be given away to target shareholders as control premium.