The Importance Of Discounted Cash Flow Techniques

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02 Nov 2017

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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 movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.

The statement of cash flows is prepared to measure the cash in-flows and cash out-flows from the operating, investing and financing activities of a business during a period.

It is a summary of all the transactions that affect cash.

It shows how the cash moved during the period.

The term cash as used in the statement of cash flows refers to both cash and cash equivalents.

Cash flow statement provides relevant information in assessing a company's liquidity, quality of earnings and solvency.

Discounted Cash Flow (DFC):

In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs)—the sum 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.

Using DCF analysis to compute the NPV takes as input cash flows and a discount rate and gives as output a price; the opposite process—taking cash flows and a price and inferring a discount rate, is called the yield.

Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management.

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

The main idea behind a Discounted Cash Flow (DFC) model is relatively simple – a stock's worth is equal to the present value of all its estimated future cash flows. Putting this idea into practice is where the difficulties lie.

The Financial Manager identifies the nature and timing of all the cash-flows relating to the proposal. Any initial investment required 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 expected to occur. Then a net cash-flow for each year of the proposal is calculated.

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 evaluated. Usually the one selected will be the "least cost" option. This will be the proposal that will have the negative NPV that is closest to zero. Thus the ultimate decision to invest or not will be made.

It is worth noting that, other than the NPV approach, there are variations of the DCF approach which are used to assess capital expenditure proposals.

Once we project the cash flows we expect a company to generate in the future, we have to discount those future cash flows back to the present to account for the time value of money. After all, Cash today is worth more than Cash 10 years from now, because the Cash today can be invested to earn a return over the next 10 years.

Example:

X company invest money @ 4% annual rate of return. In that case, $ 1 today will become $1.04one year from now. Two years from now, it will become $1.0816 ($1.04 x $1.04). Three years from now, it will become $1.1576, and so on.

To find the present value of $1 of future cash flow, divide that future cash flow by the appropriate multiplier from the above example. A cash flow of $ 1 one year in the future is worth $0.9524 ($1/$1.05) in the present. If we invest that $0.9524 @ 5%, in one year we'll have exactly $1. A $1 cash flow two years in the future is worth $1/$1.052, or $0.9070, in the present. The further into the future we go, the less a given cash flow is worth right now. Generalizing this concept, the following formula is quite important:

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

Here,

CF = Cash Flow

R = Required Return (Discount Rate)

N = Number of Years in the Future

Suppose we have a $1,000 cash flow three years in the future with a 7% rate of return. The present value of that cash flow is:

$1,000 / (1 + .07) ^3 = $816.30

The same cash flow five years in the future would be worth:

$1,000 / (1 + .07) ^5 = $712.99

And finally, a $1,000 cash flow five years from now, but this time with a 10% discount rate, would be worth:

$1,000 / (1 + .10) ^5 = $620.92

As you can see from these examples, the further out a cash flow is, the less it is worth in today's cash. Also, the higher the rate of return used to discount the future cash flow, the lower 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

Profitability is the primary goal of all business ventures. Without profitability the business will not survive in the long run. So measuring current and past profitability and projecting future profitability is very important. Profitability can be defined as either accounting profits or economic profits.

Portability is the net result of a number of policies and decisions. The ratios examined thus far provide useful clues as to the effectiveness of a firm’s operations, but the profitability ratios show the combined effects of liquidity, asset management, and debt on operating results.

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 occurs because costs are too high. High costs, in turn, generally occur because low GP%. However, In such a case, the low profit margin would not indicate an operating 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 relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

In ordinary parlance working capital is taken to be the fund available for meeting day to day requirements of an enterprise.

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 alone in others.

These costs occur gradually in a flow and do not come into being abruptly at a given moment.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

If the industry average cash conversion ratio is 25 the company is better off than other companies.

Shorter the cash conversion cycle the better the company is off because it has to lock up cash for a relatively smaller period of time.

This means that on average it takes 80 days for a company to turn purchasing inventories into cash sales.

In regards to accounting, operating cycles are essential to maintaining levels of cash necessary to survive.

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

Given these data, knows when it starts producing that it will have to finance the manufacturing costs for respectively 18, 15 & 55-day period. The firm’s goal should be to shorten its cash conversion cycle as much as possible without hurting operations. This would increase RTC’s value, because the shorter the cash conversion cycle, the lower the required net operating working capital, and the higher the resulting free cash flow.

The cash conversion cycle can be shortened

by reducing the inventory conversion period by processing and selling goods more quickly,

by reducing the receivables collection period by speeding up collections,

or

By lengthening the payables deferral period by slowing down the firm’s own payments. To the extent that these actions can be taken without increasing costs or depressing sales, they

Should be carried out.

Answer to the Question No. 2 (c)

Investment Ratio

Investment Ratio is the relationship between an amount of money invested and the profit made from it. To research possible investments, we read financial reports, prospectuses, and all manner of number- and jargon-filled analyses. Investors use different ratios to boil that information down into usable chunks to make sound investment decisions. There are four key types of Investment Ratios – 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 arguing that managers should take steps to maximize the firms’ stock price, we have said nothing about the traditional objective, profit maximization, or the maximization of earnings per share (EPS). However, while a growing number of analysts rely on cash flow projections to assess performance, at least as much attention is still paid to accounting measures, especially EPS. The traditional accounting performance measures are appealing because

1) they are easy to use and understand;

2) they are calculated on the basis of more or less standardized accounting practices, which reflect the accounting profession’s best efforts to measure financial performance on a consistent basis both across firms and over time;

and

3) net income is supposed to be reflective of the firm’s potential to produce cash flows over time.

Management must communicate the reason for the earnings decline, for otherwise the company’s stock price will probably decline after the lower earnings are reported.

Finally For planning and control purposes, management generally forecasts monthly (or perhaps quarterly) income statements &EPS, and it then compares actual results to the budgeted statements. If revenues are below and costs above the forecasted levels, then management should take corrective steps before the problem 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.

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