This paper will evaluate the Discounted-Cash-Flow-Method (DCF) as a certain value based performance measurement system (VBPMS). Therefore criteria of evaluating performance measurement systems (PMS) in generally will be created (Chapter 2). This strategy will guarantee the fundamental comparability of the derived features of the DCF with these of other PMS (including non-VBPMS, too). Chapter 3 will emphasize a fundamental feature of VBPMS, the shareholder orientation. After a detailed investigation of the DCF in chapter 4, its criteria will be evaluated in chapter 5. Finally a quintessence closes this paper (chapter 6).
2 Criteria for evaluating performance measurement systems
In this chapter criteria of value based performance measurement systems will be developed. Therefore the sense of performance in connection with enterprises will be explained, at first. Finally, the term “performance measurement system” (PMS) will be defined in order to point out there criteria.
2.1 The performance of an enterprise
Performance of an enterprise stands for its achievement, its power or its output 1 . To describe this term exactly, it is important to get an impression of the objectives of an enterprise (see Figure 7.1).The objectives of an enterprise are derived from its mission 2 . The mission of a company stresses its basic function in society. Qualitative aims, called goals, are derived from the mission. If they are expressed in a way that can be measured, they are called objectives. Shareholder wealth maximisation is the traditional objective of firms 3 . In general, “any group or individual who can affect or is affected by the achievement of the organization’s objectives” 4 (Stakeholder) can influence its mission and therefore its objectives. And some of them do so, as one can realise for example by investigating the success of the Balanced Score Card 5 as a performance measurement instrument that emphasises the objectives of several stakeholders 6 . Obviously, not every Stakeholder can by considered. Only the interests of a few key-stakeholders will be regarded by the target system of a firm. Shareholders are one of the considered key-stakeholders because of their influence on the process of creating the mission (consider the rights of co determination of the general business meeting and the supervisory board 7 at share companies; the influence of the shareholders on partnerships is trivial).
Table of Contents
1 INTRODUCTION
2 CRITERIA FOR EVALUATING PERFORMANCE MEASUREMENT SYSTEMS
2.1 THE PERFORMANCE OF AN ENTERPRISE
2.2 PERFORMANCE MEASUREMENT SYSTEMS
3 VALUE BASED PERFORMANCE MEASUREMENT SYSTEMS (VBPMS)
4 THE DISCOUNTED CASH FLOW METHOD - DCF
4.1 THE PRINCIPLE OF THE DCF
4.2 HOW CAN THE SHAREHOLDER VALUE BE MEASURED WITH THE DCF
4.2.1 WACC
4.2.2 OPERATING CF
4.2.3 RESIDUAL VALUE
4.3 PLANNING
4.3.1 CAPITAL INVESTMENT PLANNING
4.3.2 DIVISIONAL INVESTMENT MANAGEMENT PROCESS
4.3.3 GENERAL PLANNING PROCESS
4.3.4 SUMMARY PLANNING
4.4 NAVIGATING AND MONITORING
5 EVALUATION OF THE DISCOUNTED CASH FLOW METHOD
5.1 THE STAKEHOLDERS THAT ARE CONSIDERED BY VBPMS
5.2 COGNITIVE MODEL
5.3 STRATEGIC BIAS
5.4 TARGET CONFORMITY
5.5 FEED-BACK FUNCTION
5.6 FEED-FOREWORD-FUNCTION
5.7 RELEVANCE FOR PRAXIS
6 QUINTESSENCE
Objectives and Key Themes
This paper examines the Discounted Cash Flow (DCF) method as a central instrument within Value Based Performance Measurement Systems (VBPMS). The primary research objective is to critically evaluate whether the DCF method—originally developed for valuation—can effectively function as a management and control system, and to identify the necessary conditions and limitations for its successful implementation within an enterprise.
- Theoretical evaluation of criteria for modern performance measurement systems.
- Detailed analysis of the Discounted Cash Flow (DCF) methodology and its mathematical components (WACC, Operating Cash Flow, Residual Value).
- Examination of the DCF's application in planning, investment decision-making, and organizational control.
- Critical assessment of shareholder orientation vs. stakeholder integration in management practice.
Excerpt from the Book
4.2.1 WACC
Rappaport suggests the WACC as the discount rate for discounting the Cash-flows and the residual value to the corporate value exclusive the marketable securities. The WACC estimates the yield that investors anticipate at least when investing their money. It is the weighted average of the cost of equity and the cost of debt capital. Rappaport emphasizes that the relative weights attached to debt and equity are “based on the proportions that the firm targets for its capital structure over the long term planning period”.
The following three chapters will investigate the derivation of the cost of equity, of the cost of debt capital and of the capital structure.
4.2.1.1 The cost of equity
The cost of equity is estimated by the CAPM. The CAPM is originally an approach of the portfolio selection theory created in the 60th by Sharp, Lintner and Mossin. It derives the cost of equity from the risk-free rate “as reflected in the current yield available in government securities” plus an additional equity risk premium. Assuming that the unsystematic risk of security papers can be diversificated by the investors, this equity risk premium has only to contain the individual security’s systematic risk relative to those of the market (as measured by the β-coefficient) and the estimated risk-premium of the market.
Summary of Chapters
1 INTRODUCTION: Outlines the scope of the paper, focusing on the evaluation of the DCF method within performance measurement systems.
2 CRITERIA FOR EVALUATING PERFORMANCE MEASUREMENT SYSTEMS: Defines performance in an enterprise context and establishes a criteria catalogue for assessing PMS effectiveness.
3 VALUE BASED PERFORMANCE MEASUREMENT SYSTEMS (VBPMS): Explains the shareholder value approach and how value-oriented controlling instruments are integrated into a VBPMS.
4 THE DISCOUNTED CASH FLOW METHOD - DCF: Provides a comprehensive technical breakdown of the DCF method, covering calculation principles, WACC, cash flow, planning, and monitoring.
5 EVALUATION OF THE DISCOUNTED CASH FLOW METHOD: Critically reviews the DCF against the established performance criteria, discussing stakeholder orientation, strategic bias, and practical relevance.
6 QUINTESSENCE: Synthesizes the findings, concluding that the DCF requires integration with other planning and incentive tools to function as an effective performance system.
Keywords
Discounted Cash Flow, DCF, Value Based Performance Measurement Systems, VBPMS, Shareholder Value, WACC, Cost of Equity, Controlling, Strategic Planning, Stakeholder Orientation, Performance Measurement, Incentive Systems, Corporate Valuation, Capital Structure, Operational Management
Frequently Asked Questions
What is the core focus of this research?
The paper evaluates the Discounted Cash Flow (DCF) method specifically as a tool for managing and measuring enterprise performance, rather than just as a financial valuation method.
Which central topics are addressed?
Key topics include the mathematical derivation of shareholder value, the role of Weighted Average Cost of Capital (WACC), strategic planning processes, and the interaction between incentive systems and performance indicators.
What is the main objective of the study?
The primary goal is to determine if the DCF method, when implemented as a VBPMS, can effectively support the management of a firm's performance and align employee actions with shareholder objectives.
Which scientific methodology is applied?
The study employs a literature-based theoretical analysis, contrasting traditional performance metrics with value-based approaches and critically evaluating the requirements for effective management control systems.
What does the main body of the text cover?
It provides a rigorous breakdown of DCF mechanics (including the estimation of beta and residual value) and examines how these figures influence capital investment planning and operational control cycles.
Which keywords best characterize this work?
The work is defined by terms such as Value Based Performance Measurement Systems, DCF, Shareholder Value, Controlling, WACC, and Strategic Planning.
Does the DCF method solve the principal-agent problem?
The author concludes that the DCF does not fully solve the principal-agent problem between investors and managers, as the strategic requirements of DCF-based systems are often in tension with the need for manipulation-proof operative indicators.
Why is the estimation of divisional beta considered problematic?
The author highlights that deriving divisional beta-coefficients is inherently imprecise due to the need for specific leverage estimations and the reliance on historical market data, which often fails to capture individual risk management strategies.
- Quote paper
- Jens Jannasch (Author), 2003, Critical Evaluation of the Discounted Cash Flow-Method as a Value Based Performance Measurement Concept, Munich, GRIN Verlag, https://www.grin.com/document/22886
