Discounted Cash Flow Techniques - Coursework Example

Accounting work Discounted cash flow techniques Discounting cash flow involves finding the present values of future cash flows of a project.“The process is actually the inverse of compounding interest. Instead of finding future value of present dollars at a given rate, discounting determines the present value of future amount, assuming an opportunity to earn a certain return on the money.” (Lawrence J Gitman, 2006, page 169)i. DCF methods of investment appraisal include internal rate of return (IRR) method and net present value (NPV) method. In this write up an effort is made to find out whether the applicability of these DCF methods for investment appraisal adds to the value of firm. Long term investments involve commitment of sizeable amount of funds for a long period of time. Therefore it is important that there should be procedures to evaluate capital expenditures alternatives in order to select appropriate option for the business. One of the important tasks in capital budgeting or investment appraisal is estimating future cash flows for a project. The firm invests cash now in the hope of receiving cash returns in a greater amount in the future. For any investment project cash outflows and inflows play an important role. For each investment proposal, the cash flow information is required on incremental basis, so that we may analyze only the difference between the cash flows of the firm with or without the project. In any investment appraisal process, there are initial cash outflows called initial investments, operating cash inflows, and finally on completion of the project terminal cash flows are involved. On determination of estimated cash flows for each investment, firm has to undertake a decision to accept or reject the proposal of investment. “When analyzing any complex cash flow problem it is important to remember the basic time value money (TVM) concept that the value of money changes with time and if you wish to add or compare, they must be from the same period.”(J Edward Pope, 1997, page 379)ii Decision making or approval of an investment out of many options requires the computation of present values of cash flows, also called discounted cash flows. “Discounted cash flows follow the fundamental economic principle that the value of an asset is the present value of the expected cash flow from using that asset” (Constance Lutolf Carroll and Antii Pirnes, 2009, page 396)iii There are methods of investment appraisal other than those based on discounted cash flow analysis, like average rate of return and payback method. These methods contain certain shortcomings in their process of investment appraisal. Like, average rate of return is more appropriately treated as a constraint to be satisfied than a profitability measure to be maximized. Similarly, pay back method like the average rate of return ignores the time value of money. Benefits in the last year are valued as the benefits in the first year. “Like average rate of return, payback method does not account for value of time, nor does it serve as a measure of profitability.” (Angelico A. Groppelli and Ehsan Nikbakhat,2006, page 159)iv. Simply these methods do not add values while appraising the projects. Whereas the methods based on discounted cash flows provide a more objective basis for evaluating and selecting investment projects. These methods take into account of both magnitude and timings of expected cash flows in each period of project’s life. “The discounted cash flow methods offer a valuation based on future earning capacity and recent financial performance. The theory behind the discounted future cash flows of a business entity is worth its expected future earnings” (Garry L Moss and G. Shaw- McMinn, 2001, page 283)v . When fair value of an entity is measured, the relative weightage of debts and equity is determined in calculation of weighted average cost of capital. “A corollary to measure fair value of the equity using a DCF method at the WACC is to calculate internal rate of return (IRR) on the investment. The IRR is the discount rate that makes the present value of expected debt free future cash flow equal to investment. In financial theory IRR should approximate the WACC” (Mark L. Zyla, 2009, page 377)vi Thus discounted cash flow methods take care of future value being added to the value of the entity when considered for an investment. “Unfortunately DCF does not solely depend on discount rate. It incorporates a variety of factors that influence value.” (Peter A. Hunt, 2009, page 42)vii. These factors include free cash flow, forecast value, terminal value among others. Two discounted cash flow methods are inter rate of return and net present value method. “Internal rate of return is the rate of return which, when used to discount an investment’s future cash flows, makes the NPV of the investment equal zero. In other words, when the future cash flow of an investment is discounted using the IRR, their PV will exactly equals the initial investment amount.”(J Edward Pope, 1997, page 382)viii The acceptance criterion generally employed with the internal rate of return method is to compare the internal rate of return with a required rate of return, known as cut off or hurdle rate. If the internal rate of return exceeds the required rate, the project is accepted; if not, it is rejected. Accepting a project with internal rate of return in excess the required rate of return should result in an increase in market price of the stock, because the firm accepts a project with return greater than required to maintain the present market price per share. Like the internal rate of return method, the net present value method is a discounted cash flow approach to capital budgeting. “NPV describes a way to characterize the value of an investment, and the net present value is a method of choosing among alternative investments.” (Richard Armand and others,2007, page 40)ix With present value method, all cash flows are discounted to present value, using the required rate of return. A project is accepted when net present value of future cash flow is greater than its initial cost, otherwise the proposal is rejected. With the NPV method, we are given cash flows and the required rate of return, and we solve the net present value. The acceptability of the proposal depends on whether the net present value is zero or not “The critical point of this method is in deciding which discount rate to use in the calculations of NPV. When the interest rates go up, financing project become more expensive; therefore, cash flows of the projects should be discounted at a higher rate than when the interest rate is declining.”(Angelico A. Groppelli and Ehsan Nikbakhat,2006, page 159)x. Therefore under both the DCF methods, the deciding factor is interest rate; and that has to be higher than the required rate of return to get the assent of the management for a project. Conclusion: DCF methods of investment appraisal use interest rates either to compare the internal rate of return with the required rate of return, or to find net present value of the future cash flows. This interest rate should be higher than the required rate of return to get the nod of the management. Higher rate of return brings profitability to the entity. Therefore, it is proved that application of DCF methods for investment appraisal adds to the value of the firm. Accordingly I agree that ‘investment appraisal should add value to the business organization,’ 2. Project A IRR is 18% and NPA (or NPV) is $ 72300 Project B Initial investment is $293230 and NPA is $71960. Project 3 PV of FCF – Initial Investment (I) = NPA or NPV PV of FCF = I + NPV PV of FCF = 200000 + 35624 = 235624 n NPV= ∑ (CFt * PVIF kj ) –CFo , where t=1 CFt = Cash inflow discounted at rate equal to firm’s cost of capital CFo = Initial investment PVIF kj = cost of capital n NPV= ∑ (CFt * PVIF kj ) –CFo= 235624 t=1 or 35624 * PVIF kj = 235624, or PVIF = 235624/35624 or 6.661 or approximated to 7% Annual net cash flow is calculated using PVIF 7% with the help of excel sheet below = $ 35550 app. Project 4 IRR is 15% and Annual Net cash flow is $60000 computed with the help of excel sheet as under: Therefore project B will be my choice as its IRR is 20% against the cost of capital of 14%, and accordingly project B is adding more value to the firm than any other firm. 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