Finance and groowth strategy - Essay Example

This phenomenon makes the valuation of any potential investment a cumbersome task for any decision-maker. For this purpose, several valuation models have been developed that have been tested academically and professionally as being effectively helpful in analyzing investment projects, such as the discounted cash flow, present value, Tobin's q, etc. The discounted cash flow is regarded as the most important technique in evaluating long-term investment decisions, in particular. Reilly and Brown (2003) consider the calculation of discounted cash flow to be the most commonly practiced technique for the valuation of assets.

The model is specifically utilized in large organizations as an effective means to analyze an investment on the basis of returns expected within a certain number of years. For instance, a company wants to invest a certain sum of money (See Table 1 and 2) to purchase an asset that is likely to benefit the company and provide a flow of income for the period of five years. This company can utilize the DCF method to reach an appropriate decision concerning whether to buy the asset or not. The asset will be purchased if the Net Present Value (NPV) calculated appears to be positive, whereas the company will not go for this investment if the NPV is less than zero or negative.

This model evaluates the value of a company's asse. Wolfe and Gold (2004, p191) state that, "with the discounted cash flow theory cash flows are discounted at a risk-adjusted discount rate to arrive at an estimate of value". Thus, this method utilizes a discount rate to evaluate the cash flows expected from the use of the asset. In the following example (See Table 2), the discount rate is taken as 15%, whereas the investment is evaluated for the period of five years. After discounting the cash flows expected to be received in the given years, the present value is obtained.

Table 1Cash Flows*Considering Expected Inflation =3% Year 1 Year 2 Year 3 Year 4 Year 5 Cash Inflow* $7,519,000 $7,594,190 $7,669,380 7035528 6497543Less: Operating Costs $1,460,000 $1,503,800 $1,548,914 $1,595,381 $1,643,242 Less: Depreciation $2,266,667 $2,266,667 $2,266,667 $2,266,667 $2,266,667Operating Income BT $3,792,333 $3,823,723 $3,853,799 $3,173,480 $2,587,634 Tax (10% assumed) $379,233 $382,372 $385,379 $317,348 $258,763Operating Income AT $3,413,099 $3,441,350 $3,468,419 $2,856,132 $2,328,870 Add: Depreciation $2,266,667 $2,266,667 $2,266,667 $2,266,667 $2,266,667Cash Flows $5,679,766 $5,708,017 $5,735,086 $5,122,799 $4,595,537Table 2Year Cash FlowsDiscount Rate- 15%Present Value1$5,679,7660.

8704,941,3962$5,708,0170.7574,320,9683$5,735,0860.6583,773,6864$5,122,7990.5722,930,2415$4,595,5370.4972,283,981Net Present Value18,250,272- Explicating The Investment RisksFrench and Gabrielli (2005, p80) illuminate that "the DCF method can mirror the all risk yield approach by explicitly applying all the assumptions that have been implicitly allowed for". The preeminence of this method lies in pre-identifying the risks concerning a prospective investment while