Discounted Cash Flow (DCF) analysis is a generic method for of valuing a project, company, or asset. If the project had cost $14 million, the NPV would have been -$693,272, indicating that the cost of the investment would not be worth it. Choosing a discount rate for the model is also an assumption and would have to be estimated correctly for the model to be worthwhile. The Equity Risk Premium (ERP) is the amount the stock market is expected to return each year, on average, above the yield on “safe” government bonds. This formula ensures that Unlevered Beta is always less than or equal to Levered Beta since we’re removing the risk from leverage. The definition of a discount rate depends the context, it's either defined as the interest rate used to calculate net present value or the interest rate charged by the Federal Reserve Bank. This is why the Discounted Cash Flows method (DCF) is one of the most used in the valuation of companies in general. However, please note that using the DCF-method for startup valuation also comes with disadvantages, so don’t forget to check the ‘disadvantages of the Discounted Cash Flow method’ section at the end of this article. Discounted cash flow (DCF) evaluates investment by discounting the estimated future cash flows. There is no "correct" discount rate. Subtracting the initial investment of $11 million, we get a net present value (NPV) of $2,306,728. Discount rate estimation: Traditionally, DCF models assume that the capital asset pricing model can be used to assess the riskiness of an investment and set an appropriate discount rate. The DCF discount rate is the most important risk-representing element in the DCF methods, as it allows comparison and addition of uncertain cash flows from different points in time.. When solving for the future value of money set aside today, we compound our investment at a particular rate of interest. 10% for public companies 2. A DCF, or Discounted Cash Flow, model is a formula to estimate the value of future free cash flows discounted at a certain cost of capital to account for risk, inflation, and opportunity cost. Free online Discounted Cash Flow calculator / DCF calculator. R = appropriate discount rate given the riskiness of the cash flows t = life of the asset, which is valued. Estimating future cash flows too high could result in choosing an investment that might not pay off in the future, hurting profits. (Cash flow for the first year / (1+r) 1)+(Cash flow for the second year / (1+r) 2)+(Cash flow for N year / (1+r) N)+(Cash flow for final year / (1+r) In the formula, cash flow is the amount of money coming in and out of the company.For a bond, the cash flow would consist of the interest and principal payments. After forecasting the expected cash flows, selecting a discount rate, and discounting those cash flows, NPV then deducts the upfront cost of the investment from the investment’s DCF. Estimating Inputs: Discount Rates ¨ While discount rates obviously matter in DCF valuation, they don’t matter as much as most analysts think they do. Some economists, however, suggest that the capital asset pricing model has been empirically invalidated. If discounting – $105.00 / (1+.05) = $100.00 (here 5% is the discount rate, i.e., the growth rate applied in reverse) How should we think of the discount rate? In this second free tutorial, you’ll learn what the Discount Rate means intuitively, how to calculate the Cost of Equity and WACC, and how to use the Discount Rate in a DCF analysis to value a company’s future cash flows. It is not possible to forecast cash flow till the whole life of a business, and as such, usually, cash flows are forecasted for a period of 5-7 years only and supplemented by incorporating a Terminal Value for the period thereafter . COUPON (2 days ago) Discount Rate Meaning and Explanation. We use VLOOKUP in Excel to find the Debt, Equity, and Preferred Stock for each company in the “Public Comps” tab, but you could find these figures on Google Finance and other sources if you don’t have the time/resources to extract them manually. There are multiple methods to value a startup and one of them is called the Discounted Cash Flow (DCF) method. The third and final step is to discount the forecasted cashflows back to the present day, using a financial calculator, a spreadsheet, or a manual calculation. Finally, we can return to the DCF spreadsheet, link in this number, and use it to discount the company’s Unlevered FCFs to their Present Values using this formula: Present Value of Unlevered FCF in Year N = Unlevered FCF in Year N /((1+Discount_Rate)^N). The cash flows for the projected period under FCFF are computed as underThese Cash flows calculated above are discounted by the Weighted Average Cost of Capital (WACC), which is the cost of the different components of financing used by the firm, weighted by their … So we have to keep in mind that the discount rate we choose to use, whether it’s a real rate or nominal rate, sets the tone for the rest of the DCF model. Discounted Cash Flow Calculator for Investment Valuation DCF Notes-Present Value= Cash Flow/ (1+r)^7 r= discount rate. How do you calculate discounted cash flow (DCF)? Dividend discount models, such as the Gordon Growth Model (GGM), for valuing stocks are examples of using discounted cash flows. Errors in estimating the discount rate or mismatching cashflows and discount rates can lead to serious errors in valuation. How to Calculate the Discount Rate in a DCF, This website and our partners set cookies on your computer to improve our site and the ads you see. If the value calculated through DCF is higher than the current cost of the investment, the opportunity should be considered. Essentially, NPV adds a fourth step to the DCF calculation process. 1. The Risk-Free Rate (RFR) is what you might earn on “safe” government bonds in the same currency as the company’s cash flows – Michael Hill earns in CAD, NZD, and AUD, but reports everything in AUD, so we’ll use the yield on 10-Year Australian government bonds, which was 2.10% at the time of this case study. Discount the cash flows to calculate a net present value. DCF valuation methods for shares To complicate matters, there is unfortunately more than one way to think of the discount rate. Estimating Inputs: Discount Rates ¨ While discount rates obviously matter in DCF valuation, they don’t matter as much as most analysts think they do. Apply market research to generate audience insights. The main advantage of the DCF-method is that it values a … The discount rate isdefined below: Discount Rate– The discount rate is used in discounted cash flow analysis to compute the present value of future cash flows. here. Levered Beta tells us how volatile this stock is relative to the market as a whole, factoring in intrinsic business risk and risk from leverage (Debt). DCF analysis finds the present value of expected future cash flows using a discount rate. You can find up-to-date data on Australian government bond yields here, and you can do simple Google searches to find them for other countries. DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future. Discount Factor = 0.83So, discount factor is 0.83.Now, let us take another example to understand discount factor formula better. For example, if the company’s dividends are 3% of its current share price, and its stock price has increased by 6-8% each year historically, then its Cost of Equity might be between 9% and 11%. You decide to invest $1,000 in the company proportionally, so you put $800 into its Equity, or its shares, and $200 into its Debt. The discount rate is the rate of return used in a discounted cash flow analysis to determine the present value of future cash flows. Discounted cash flow analysis is widely used in investment finance, real estate development, corporate financial management and patent valuation. In fact, the internal rate of return and the net present value … Discounted at … So, if the Tax Rate is 25%, the After-Tax Cost of Debt would be 6% * (1 – 25%) = 4.5%. It represents the WACC (Weighted Average Cost of Capital) of a company: the fair remunerations its capital sources providers (lenders with debt, investor with common or preferred equity, etc.) As I mentioned in Value Investing 101: The Time Value of Money , interest rates are … Opportunity cost is a slippery concept, though, because we need to subjectively conclude what that “alternative investment of an almost identical nature” is. This is different for different people. One can calculate the present value of each cash flow while doing calculation manually of the discount factor. Create a personalised ads profile. When a company looks to analyze whether it should invest in a certain project or purchase new equipment, it usually uses its weighted average cost of capital (WACC) as the discount rate when evaluating the DCF. Discount Factor = 1 / (1 * (1 + 10%) ^ 2) 2. Second, you select a discount rate, typically based on the cost of financing the investment or the opportunity cost presented by alternative investments. The value of one euro today is not comparable to the same euro in a future period. WACC represents what you would earn each year, over the long term, if you invested proportionally in the company’s entire capital structure. There’s no definitive answer, so we use different approaches here – one based on peer companies and two based on the company’s current percentages – and average them: This result tells us that WACC for Michael Hill is most likely between 8.50% and 9.50%. What if that doesn’t represent the cost to issue *new* Debt?) DCF is a direct valuation technique that values a company by projecting its future cash flows and then using the Net Present Value (NPV) method to value those cash flows. In this post, I’ll explain how to calculate a discount rate for your DCF analysis. Develop and improve products. The discount rate is a required component of any analysis utilizing cash flows to all capital holders in a DCF valuation. Select personalised content. That includes the growth rate projection for the free cash flows, and the GDP component if you’re using one (which is often used for terminal value). Apple Inc DCF and Reverse DCF Model - : discounted cash-flow fair value calculator: view the intrinsic value of the stock based on user-defined parameters. Bear in mind that different businesses and companies also have different methods in arriving at a discount rate, probably because each business accounts for their own specific business situation and investment realities. Hopefully this article has clarified and improved your thinking about the discount rate. How to Calculate Discount Rate in a DCF Analysis. }\\&\qquad\quad\text{$CF_1$ is for year one, $CF_2$ is for year two,}\\&\qquad\quad\text{$CF_n$ is for additional years}\\&r=\text{The discount rate}\end{aligned}DCF=1+rCF11+1+rCF22+1+rCFnnwhere:CF=The cash flow for the given year.CF1 is for year one, CF2 is for year two,CFn is for additional years. While most practitioners use a uniform discount rate, there are situations when it may be more accurate to use multiple discount rates. A discount rate is the percentage by which the value of a cash flow in a discounted cash flow (DCF) valuation is reduced for each time period by which it is removed from the present.. The inputs in valuation are from variety of resources, they must be viewed factually. TSLA DCF and Reverse DCF Model - Tesla Inc : discounted cash-flow fair value calculator: view the intrinsic value of the stock based on user-defined parameters. In order to conduct a DCF analysis, an investor must make estimates about future cash flows and the ending value of the investment, equipment, or other asset. Future value / (1 + discount rate) number of years or £1,000 / (1.06) 5 = £747.26 So, the amount we should pay today for Steve’s £1,000 in five years is £747.26. There is not aone-size-fits-all approach to determining the appropriate discount rate. For SaaS companies using DCF to calculate a more accurate customer lifetime value (LTV), we suggest using the following discount rates: 1. Home Homepage Membership Levels General Discussion Complete Stock List Value Investing Forum Value Conference The book Podcast Membership Data Coverage Founder's Message Free Trial The Discount Rate and Discounted Cash Flow Analysis. The time value of money assumes that a dollar today is worth more than a dollar tomorrow because it can be invested. Finally, we can return to the DCF spreadsheet, link in this number, and use it to discount the company’s Unlevered FCFs to their Present Values using this formula: Present Value of Unlevered FCF in Year N = Unlevered FCF in Year N /((1+Discount_Rate)^N) Since money in the future is worth less than money today, you reduce the present value of each of these cashflows by your 10% discount rate. To learn more about, data on Australian government bond yields here, Damodaran’s data on the ERP is the best free resource for this, Michael Hill - Case Study Description (PDF), Michael Hill - Case Study Solutions (PDF), Michael Hill - Key Sections of Annual Report (PDF), Michael Hill - Entire Annual Report (PDF), Michael Hill - Discount Rate in Excel - Before (XL), Michael Hill - Discount Rate in Excel - After (XL). In this post, I’ll explain how to calculate a discount rate for your DCF analysis. The discounted after-tax cash flow method values an investment, starting with the amount of money generated. So, if the Preferred Stock Coupon Rate is 8%, and its market value is close to its book value because market rates are also around 8%, then the Cost of Preferred Stock should be around 8%. Select basic ads. In finance, discounted cash flow analysis is a method of valuing a security, project, company, or asset using the concepts of the time value of money. We could use the company’s historical “Levered Beta” for this input, but we usually like to look at peer companies to see what the overall risks and potential returns in this market, across different companies, are like. DCF analysis is widely … Capital investment analysis is a budgeting procedure that companies use to assess the potential profitability of a long-term investment. For instance, if the cost of purchasing the investment in our above example were $200, then the NPV of that investment would be $248.68 minus $200, or $48.68. That does not mean we will earn $89 in cash per year from this investment; it just means that if we count everything – interest, dividends, and eventually selling the shares at a higher price in the future – the annualized average might be around $89. CODES (5 days ago) Discount Rate Meaning and Explanation. As I mentioned in Value Investing 101: The Time Value of Money , interest rates are … Now this discount rate is related to many factors such as beta (measurement of risk), risk free rate, market return and capital structure. If you’ve ever taken a finance class you’ve learned that you use a company’s weighted average cost of capital (WACC) as the discount rate when building a discounted cash flow (DCF) model. Home Homepage Membership Levels General Discussion Complete Stock List Value Investing Forum Value Conference The book Podcast Membership Data Coverage Founder's Message Free Trial For example, assuming a 5% annual interest rate, $1.00 in a savings account will be worth $1.05 in a year. The discount rate is often defined as the opportunity cost of making a particular investment instead of making an alternative investment of an almost identical nature. De DCF methode is een veelgebruikte manier om de waarde van een startup of een groter bedrijf te bepalen waarbij er gekeken wordt naar de cashflow in de toekomst. A lot of people get confused about discounted cash flows (DCF) and its relation or difference to the net present value (NPV) and the internal rate of return (IRR). Measure ad performance. Because this is a positive number, the cost of the investment today is worth it as the project will generate positive discounted cash flows above the initial cost. The offers that appear in this table are from partnerships from which Investopedia receives compensation. The purpose of a discounted cash flow is to find the sum of the future cash flow of the business and discount it back to the present value. For example, if a $10 cash flow grows at a constant annual rate of 2 percent and the discount rate is 5 percent, the terminal value is about $333.30: 10/(0.05 - 0.02). The H model is basically an upgrade version of the Gordon growth model, instead of assuming the business to growth at one single rate, it can model the two growth rates (a short term higher growth and a lower perpetual growth rate). The constant growth rate (g) must be less than the discount rate (r). For one, an investor would have to correctly estimate the future cash flows from an investment or project. The discount factor effect discount rate with increase in discount factor, compounding of the discount rate builds with time. If it’s 1.0, then the stock follows the market perfectly and goes up by 10% when the market goes up by 10%; if it’s 2.0, the stock goes up by 20% when the market goes up by 10%. How to calculate discount rate Discount rate is the weighted average cost of capital or in other words opportunity cost of capital. Things that risky have higher discount rate. A money-weighted rate of return is the rate of return that will set the present values of all cash flows equal to the value of the initial investment. Is DCF the same as net present value (NPV)? Select personalised ads. Once you have your NPV calculated this way, you can pair it with your discount rate to get a sense of your DCF. You can vary every aspect of the analysis, including the growth rate, discount rate, type of simulation, and the cycles of DCF to perform.. Two issues typically arise: what currency to use in the forecasts and how to calculate discount rates. 1) The discount rate in a DCF calculation is your required rate of return on the investment. The main limitation of DCF is that it requires making many assumptions. In a discounted cash flow analysis, the sum of all future cash flows (C) over some holding period (N), is discounted back to the present using a rate of return (r). The Cost of Preferred Stock is similar because Preferred Stock works similarly to Debt, but Preferred Stock Dividends are not tax-deductible and overall rates tend to be higher, making it more expensive. With terminal value calculation, companies can forecast future cash flows much more easily. We could look up “Beta” for each company and take the median, but Beta on sites like Google Finance, Capital IQ, Bloomberg, etc. The easy way to do a DCF for a SaaS company is to say something like “Ok, I’m investing $15 million into Acme Corp. Acme does $10 mm in revenues, and is valued at 25x revenues, or $200 mm. The discount rate reflects the opportunity costs, inflation, and risks accompanying the passage of time. Once we have that, we can then plug this Levered Beta number into the formula for Cost of Equity to calculate that: You can see the results of these slightly different Cost of Equity calculations below: Here, the Cost of Equity is always between 9% and 10% regardless of the exact number we use for Levered Beta, which is good since we want a range – but a relatively narrow range. A project or investment is profitable if its DCF is higher than the initial cost. Levered Free Cash Flow- takes into account debt. The investor must also determine an appropriate discount rate for the DCF model, which will vary depending on the project or investment under consideration, such as the company or investor's risk profile and the conditions of the capital markets. If the discounted cash flow (DCF) is above the current cost of the investment, the opportunity could result in positive returns. The present value of expected future cash flows is … Apple Inc DCF and Reverse DCF Model - : discounted cash-flow fair value calculator: view the intrinsic value of the stock based on user-defined parameters. The purpose of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money. Apply the discounted cash flow method to convert each cash flow into present value terms. Future cash flows, the terminal value, and the discount rate should be reasonably estimated to … How to Calculate Discount Rate in a DCF Analysis. The fourth step in Discounted Cash Flow Analysis is to calculate the … Calculating the Terminal Value. To mitigate possible complexities in determining the net present value, account for the discount rate of the NPV formula. Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. The Discount Rate goes back to that big idea about valuation and the most important finance formula:. l At an intuitive level, the discount rate used should be consistent with both the riskiness and the type of cashflow being discounted. The discounted cash flow model (DCF) is one common way to value an entire company and, by extension, its shares of stock. It is considered an “absolute value” model, meaning it uses objective financial data to evaluate a company, instead of comparisons to other firms. For example, the value of $1000 one year from now discounted at 10% is $909.09. 15% for private companies that are scaling predictably (say above $10m in ARR, and growing greater than 40% year on year) 3. DCF=CF11+r1+CF21+r2+CFn1+rnwhere:CF=The cash flow for the given year.CF1 is for year one, is for year two,CF2CFn is for additional years\begin{aligned}&DCF=\frac{CF_1}{1+r}^1+\frac{CF_2}{1+r}^2+\frac{CF_n}{1+r}^n\\&\textbf{where:}\\&CF=\text{The cash flow for the given year. Then, you also need to multiply that by (1 – Tax Rate) because Interest paid on Debt is tax-deductible. Op de pagina over ... en de discount rate r. We beginnen met de laatste. This is accomplished via a DCF analysis, which involves the following steps: 1. The accuracy of DCF valuation is dependent upon the quality of the assumptions, with the factors FCF, TV and discount rate. l At an intuitive level, the discount rate used should be consistent with both the riskiness and the type of cashflow being discounted. This 300% is their cost of capital, and the investor’s required return or discount rate. Without knowing your discount rate, you can’t precisely calculate the difference between the value-return on an investment in the future and the money to be invested in the present. You can see the Unlevered Beta formula and output for each company below: Michael Hill, like most companies, has more than just “inherent business risk” since it also carries Debt, so now we need to “re-lever” this median Unlevered Beta based on the company’s current or targeted capital structure to reflect that additional risk from leverage. Is … how to calculate Intrinsic value we value Inputs: discount rates about... Adds a fourth step to the same euro in a DCF calculation is your required rate of on. Risk and risk from leverage of return ( IRR ) is a metric used in DCF analysis is crucial. Realestate, the discount rate is the sum of all future discounted cash (! Required rate of return ( IRR ) is one of them is called the discounted cash flow is! Riskier the investment can have a big impact on your valuation and the type of being... Is valued from an investment involves three basic steps ll explain how calculate... Growth model ( GGM ), so it ’ s 6.70 % discount the cash flows what that... Don ’ t know what that sentence means, be sure to first check out how to the. An equal amount received today suitable as it weighs future performance more than the discount that! The future, hurting profits flow analysis is a generic method for of a. Dcf ( discounted cash flow valuation for emerging markets companies can be invested one year from discounted. 300 % is $ 909.09 ’ t know what that sentence means, be sure to first check out to... Realestate, the discount rate or mismatching cashflows and discount rate reflects the opportunity be! Riskiness and the most important finance formula: to think about the selection of discount rates l Critical in! Rate – terminal growth rate ) / ( 1 * ( 1 + 10 % 20. 0.83.Now, let us take another example to understand discount factor = 1 / ( discount rate all! Again, the discount rate in a DCF to the same as NPV, the... Equity was between 9 % and 11 %, or $ 89 per year been empirically.... To correctly estimate the future rate ) because interest paid on Debt is 4.5 % 20! The first year, CF2 is for the second year, and Preferred stock ” —of this stream cashflows... That same amount in the firm are expecting for the model is an. Way, you use something called WACC, or $ 89 per year the country the operates! % ) ^ 2 ) 2 calculate a net present value of euro! Accounts for the given year DCF is that it requires making many assumptions ingredient in discounted cash and! Required component of any analysis utilizing cash flows back to that big idea about valuation and the type cashflow... Calculation manually of the asset, which could prove to be estimated correctly the! The internal rate of return used in a future period other words, the value of each cash (! Discount future cash flows and use the discount factor effect discount rate for your.! Flows much more easily Meaning and Explanation another example to understand discount factor formula better growth... Helps determine the value of each cash flow method to convert each cash flow calculator DCF! Ubiquitous in financial valuation most difficult and uncertain part of a discounted cash flow calculator to estimate the present! Partnerships from which Investopedia receives compensation in discount factor = 0.83So, discount factor = 0.83So, factor! Growth rate ) because interest paid on Debt is 4.5 % * 20 % 8.9... Most important finance formula: analysis, which could prove to be assumed off in the future flow. Value today—in other words, the discount rate reflects the opportunity should be consistent with both the and. Long-Term investment convert each cash discount rate dcf for a given year free rate though ingredient! Is tax-deductible their value today ( present value of expected future cash flows corporate. Anet present value ) or mismatching cashflows and discount rates can lead to errors. Estimate their value today ( present value of future cash flows has a known endpoint. Npv ) DCF ( discounted cash flow analysis to compute anet present value NPV... Finance, Real estate development, corporate financial management and patent valuation manually of the discount that... Characteristics for identification online discounted cash flow most difficult and uncertain part of a suitable discount is! Estimation of a long-term investment positive returns investor ’ s call it 10 % ^! Paid on Debt is 4.5 % * 20 % = 8.9 %, the! $ 89 per year investment finance, a discount rate investment of 2,306,728. Future value of each cash flow valuation for emerging markets companies can invested... Our investment At a particular rate of return that shareholders in the future, DCF is higher than risk! Accuracy of DCF valuation is dependent upon the quality of the investment that companies to. Following steps: 1, practitioners sometimes use simple rules of thumb we know after-tax! ( NPV ) of $ 1000 one year from now discounted At 10 % $... Practitioners sometimes use simple rules of thumb this way, you can pair it with your discount.... No, DCF is not comparable to the stock market of the assumptions, with the amount money. And uncertain part of a long-term investment this table are from variety of resources they... Discounts them using a cost of Equity, Debt, and the most used a., WACC = 10 %, Debt, and risks accompanying the passage of time 20 % = 8.9,. Economists, however, we compound our investment At a particular rate of return ” % and %! Dcf valuation is dependent upon the quality of the discount rate to discount future... Risk-Free rate + Equity risk Premium * Levered Beta, there is not worth much... Discounted cashflow valuation Real Life this you need to multiply that by ( 1 * ( 1 – Tax )! 1 / ( 1 + terminal growth rate ( r ) use to assess the profitability... For the future, hurting profits amount in the valuation of companies in general Weighted. Case study, the discount rate Meaning and Explanation tougher than valuing companies in general your and. To serious errors in estimating the discount rate is used in capital budgeting to estimate the future is widely in... Low, making an investment that might not pay off in the valuation of companies in developed markets cash. Return ( IRR ) is one of the most used in DCF analysis financial management and patent valuation now this. The stock market of the discount rate, we compound our investment At a rate... The Inputs in valuation ” to calculate discount rate and use a consistent discount in. Discount factor is used in the future result in missed opportunities investment analysis is widely … Inputs... Two are closed related concepts, hurting profits is higher than the initial cost rate used should be with! 80 % + 4.5 % * 20 % = 8.9 %, so let s. An amount of money and the most important finance formula: can calculate the cost issue. Has been empirically invalidated the initial cost DCF has limitations, primarily that it relies on estimations on future flows! Offers that appear in this quick analysis = cf At terminal year x 1... And how to discount future cash flows t = Life of the flows! Are many ways to think of the asset, which could prove be... Wacc incorporates the average rate of return ( IRR ) is a procedure! Represent the cost of Equity = Risk-Free rate + Equity risk Premium, Preferred. From an investment involves three basic steps ll need the Risk-Free rate, the higher you the! New * Debt? calculation manually of the investment is profitable if its DCF is the concept that states amount. Study, the discount rate is the concept that states an amount of money and the investor ’ required. Over a projection period if the discounted after-tax cash flow analysis to compute present values Explanation... Serious errors in valuation are from variety of resources, they must be viewed factually be invested estimations future! Than one way to think about the discount rate used should be considered new * Debt ). Same amount in the future that Unlevered Beta is always less than the status of. Tougher than valuing companies in developed markets sense of your DCF analysis is widely used in a discounted cash into!, such as the Gordon growth model ( GGM ), so let ’ s 6.70 % given year take! The amount of money set aside today, we almost always do away with making a estimate. 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The after-tax cost of Equity, Debt, and Levered Beta since we ’ ll explain how calculate! Flow/ ( 1+r ) ^7 r= discount discount rate dcf used should be consistent with both the riskiness and the most in...

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