Discounted Cash Flow Techniques In Investment Decision

Published Date: 02 Nov 2017

To evaluate the importance of discounted cash flow techniques in investment decision, we need to understand the term Cash Flow and Discounted Cash Flow.

Cash Flow:

Cash flow is the transaction of money of a business, project, or financial product. It is calculated during a specific financial period.. Measurement of cash flow usually calculating other parameters that give companies financial strength.

Cash flows statement is prepared to view cash in-flows and cash out-flows from various activities of a business during a period.

Cash Flow shows is a summary of all the transactions that affect cash.

Cash Flow shows cash moved during the period.

Cash Flow shows refers to both cash and cash equivalents.

This statement shows relevant information in assessing a company's financial strength and solvency.

Discounted Cash Flow :

In finance, discounted cash flow analysis is a process of value of a Assets, project or company, using the ideas of the time value of money. present values (PVs) comes from All prospect cash flows are estimated and discounted —Adding of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.

Discounted cash flow analysis is use for compute the Net Present Value takes gives as output a price and as input cash flows and a discount rate

Discounted cash flow investigation is generally used in corporate financial management, real estate development, and investment finance,

Critical Evaluation of the Importance of Discounted Cash Flow Techniques in Investment Decision.

Mainly a Discounted Cash Flow form is comparatively simple – a stock's worth is equivalent to the present value of all its predictable future cash flows. Putting this plan into live out is where the difficulties lie.

The Financial Manager identifies the nature and timing of all the cash-flows relating to the suggestion. Any preliminary investment necessary is considered to be a Year 0 out-flow. Tabulate all proposed cash flows, including the taxation implications, in the year in which they are likely to take place. Then a net cash-flow for every year of the suggestion is planned.

Discount all annual cash flows successively at the selected discount rate (the discount factors can be calculated, or read from the present value tables) to arrive at the present value of each year’s cash flows. The present values of each year’s cash flows are aggregated to determine the Net Present Value (NPV) of the proposal.

For most proposals if the NPV is positive the investment should be accepted, and vice versa, subject to a consideration of the wider qualitative factors which may be relevant to the capital investment decision.

However, in most organizations there maybe some "must do" projects that have to be undertaken and which will never yield a positive NPV. A number of proposals to satisfy the projects goals will be drawn up and evaluate. Frequently the one chosen will be the "least cost" alternative. This will be the offer that will have the unconstructive NPV that is closest to zero. Thus the ultimate decision to invest or not will be made.

Which value message that, other than the NPV approach, there are variations of the DCF approach which are used to assess capital expenditure proposals.

We know Cash today is worth more than Cash 10 years from now, because the Cash today can be invested to bring in a return over the next 10 years.

Example:

XYZ invest @ 4% yearly rate of return. In this connection, $1 of present day will turn out to be $1.04 after one year. After two years, it will turn into $1.0816, and after Three years, it will develop into $1.1576 from present day.

Calculate PV of $1 of prospect cash flow, split that future cash flow by the suitable multiplier from the beyond case. A cash flow of $ 1 1st year in the prospect is worth $0.9524 in the near. If we endow that $0.9524 @ 5%, in 1st year we'll have closely $1. $1 cash flow 2nd years in the prospect is worth $0.9070, in the nearby. The additional into the prospect we go, the less a given cash flow is worth right at the present. Generalizing this idea, the following formula is moderately imperative:

Present Value of Cash Flow in Year D = CF at Year D / (1 + R)^D

Here,

CF = Cash Flow

D = Required Return (Discount Rate)

N = Number of Years in the Future

So you can observe this examples, the additional out a cash flow is, the a smaller amount it is worth in present day’s cash. Also, the upper the rate of return second-hand to discount the prospect cash flow, the minor the present value.

So we can say that discounted cash flow techniques play a vital role for investment decision.

Answer to the Question No. 2 (a)

Profitability

This is the most important objective of all business entity. Without profitability no business can go for long run. So calculating present and history profitability and analytical prospect profitability is very significant. Profitability can be clear as also secretarial profits or financial earnings.

Company

A

B

C

GP

15%

22%

40%

NP

9%

10%

12%

Return on Capital Employ

15%

13%

16%

Return on Shareholders

20

13

12

Profitability of Company "A"

A’s profit margin is 9 percent. This sub-par result happen as costs are too high. High costs, in go round, usually happen because low GP%. However, In such a case, the low profit margin would not specify an in service problem, just a difference in financing strategies. Thus, the firm with the low profit margin might end up with a higher rate of return on its stockholders’ investment due to its use of financial leverage. We will see exactly how profit margins and the use of debt interact to affect stockholder returns shortly.

Profitability of Company "B"

B’s profit margin is 10 percent. This sub-par result occurs because high cost of Raw material. High costs, in turn, generally occur because Medium GP%. However, In such a case, the profit margin would not indicate an operating problem, just a difference in financing strategies. Thus, the firm with the profit margin might end up with a rate of return on its stockholders’ investment due to its use of financial leverage. We will see exactly how profit margins and the use of debt interact to affect stockholder returns shortly.

Portability of Company"C"

C’s profit margin is 12 percent. This sub-par result occurs because Average cost of Raw material. Avg costs, in turn, generally occur because GP%. However, In such a case, the profit margin indicate an average movement of organization , just a difference in financing strategies. Thus, the firm with the profit margin might end up with a low rate of return on its stockholders’ investment due to its use of financial leverage. We will see exactly how profit margins and the use of debt interact to affect stockholder returns shortly.

Finaly we can say that Company’s gross margin is a very important measure of its profitability, because it looks at company’s major inflows and outflows of money: sales (money in) and the cost of goods sold (money out). It is a real measure of profitability, because it must be high enough to cover costs and provide for profits. Because it is an important barometer, you should monitor it closely.

In general, Company’s gross profit margin ratio should be stable. It should not fluctuate much from one period to another, unless the industry company is in is undergoing changes which affects the cost of goods sold or pricing policies. The gross margin is likely to change whenever prices or costs change.

Answer to the Question No. 2 (b)

Working Capital Management

Working capital management involves the connection between a business entity’s short-term assets and its short-term liabilities. The objective of working capital management is to make sure that a business entity is capable to carry on its operations and that has enough capability to make happy equally growing short-term debt and future operational expenses. The organization of working capital involves organization inventories, debtors and Creditor, and cash.

In usual manner of speaking of working capital is carry the finance available for covering/solved present necessities of an venture.

This working capital generates the important elements of costs viz, materials, wages, and expenses.

These costs usually lead to production and sales in case of manufacturing concerns and sales separately from others .

These costs happen progressively in a flow and do not come into being suddenly at a agreed age. It also known as ‘circulating capital’ which means current assets of a company that is changed in the ordinary course of business from one form to another.

In our Provided Data:

Company

A

B

C

Stock Day

18

25

45

Dabtors

9

32

65

Creditor

9

42

55

Conversion Cash Cycle of Working Capital of "A"

We Know

Cash Conversion Cycle

= Inventory conversion period (Stock Day) + Receivable collection period (Debtors) – Payable deferral period (Creditors)

=18+9-9

=18

Conversion Cash Cycle of Working Capital of "B"

We Know

Cash Conversion Cycle

= Inventory conversion period (Stock Day) + Receivable collection period (Debtors) – Payable deferral period (Creditors)

=25+32-42

=15

Conversion Cash Cycle of Working Capital of "C"

We Know

Cash Conversion Cycle

= Inventory conversion period (Stock Day) + Receivable collection period (Debtors) – Payable deferral period (Creditors)

=45+65-55

=55

Briefly we can say the cash conversion series the better the business is off as it has to lock up cash for a comparatively minor age of time.

By Respect of accounting, operating cycles are important to maintain level of cash essential to carry on.

A beneficial net operating cycle ratio is a life or death matter.

Given these data, knows when it starts producing which will have to funding the manufacturing costs for in that order 18, 15 & 55-day period. The firm’s objective should be to cut down its cash conversion cycle as possible without affection operations. For this reson RTC value is increase, because of the pettier the cash conversion cycle, the minor the necessary net operating working capital, and the advanced the resulting complimentary cash flow.

So finally we can see that company "B" has strong working capital maintaining ability.

Answer to the Question No. 2 (c)

Investment Ratio

This is the connection among an amount of money invested and the profit comes out from it. To investigate potential investments, we understand financial reports, prospectuses, and others way of number-& jargon-filled analysis. Investors exercise dissimilar ratios for bubble that information downward into in working condition chunks to build sound speculation decisions. Mainly 4 key types of Investment Ratios are – Asset Productivity Ratios, Financial strength ratios, Profitability ratios and Valuation ratios.

Company

A

B

C

EPS

15P

20P

25P

Price Earnings Ratio

16

12

19

Dividend yeild

7

8

4

EPS

In quarrelling –Managements should take steps to make best use of the Business’ stock price, Which is not anything about the conventional objective, earnings maximization, or the maximization of earnings per share (EPS). On the other hand, while a mounting number of analysts rely happening cash flow projections to evaluate performance, full attention is motionless rewarded to accounting events, mainly EPS. The usual accounting performance procedures are alluring because

I. Easily Understandable ;

II. Standered accounting policy use to calculate EPS, which shows the best effort of accounting profession to compute financial presentation on a reliable basis both diagonally firms and over time;

&

III. Cash flow of the business potentiality reflex by net income/earnings.

Without monitoring the fact of decline of earning company will face the probability of declining its stock value/price.

In conclusion we say that planning manage purpose, organization usually forecasts monthly/Quarterly Profit & Loss Statement &EPS, Which shows compares actual outcome to the budgeted statements. A stipulation income is below and costs on top of the forecasted levels, and then organization should take counteractive steps earlier than the difficulty becomes too serious.

In here we can see EPS is best in company "C" other than A & B.

Price earnings Ratio

Generally a high Price earnings Ratio means that investors are anticipating higher growth in the Future. The average market Price earnings Ratio is 20-25 times earnings. The Price earnings Ratio can use estimated earnings to get the forward looking P/E ratio. Companies that are losing money do not have a Price earnings Ratio.

So In here Price earnings Ratio is better in Company "B" because B shows the lowest ratio which is Positive

Dividend yield

Dividend yield is a way to measure how much cash flow you are getting for each dollar invested in an equity position

High-dividend stocks make excellent bear market investments

Company "B" shows better Dividend yield other than A&C.

Decision to Buy Share

In here if I going to buy one of these companies’ share than I will go for Company "B" Because "B" company shows Better Price earnings Ratio & Dividend yield% than Company A&B, Where Its EPS is lower than Company "C" but over all view(Ratios analysis) to take decision to buy share may be Company " B" if preferable.