L12-ECONOM

• Discounted Decision Analysis


  Also known as Discounted Cash Flow (DCF) analysis
• Discounted Decision Analysis


  A valuation method used to estimate the value of an investment based on its expected future cash flows
• DCF analysis


  Attempts to determine the value of an investment today, based on projections of how much money that investment will generate in the future
• DCF analysis


  • Can help those considering whether to acquire a company or buy securities
  • Can assist business owners and managers in making capital budgeting or operating expenditures decisions
• Main elements in valuing a corporate by Discounted Cash Flow

  1. Estimating all future cash flows

  2. Discounting them by using cost of capital to give their present values (PVs)

  3. Summing up all future cash flows, both incoming and outgoing, to obtain the net present value (NPV)
• Discount rate in DCF analysis

  The interest rate used to determine the present value of future cash flows
• Appropriate discount rate to use

  • Risk-free rate of return
  • Weighted average cost of capital (WACC)
  • Opportunity cost of putting money to work elsewhere
• DCF analysis


  • Prone to errors, bad assumptions, and overconfidence in knowing the actual worth of a company
  • Best used with other tools to validate the results, such as other valuation methods like comparable company analysis, precedent transactions, and asset-based valuation
• Purpose of DCF analysis

  To estimate the money an investor would receive from an investment, adjusted for the time value of money
• Time value of money (TVM)

  A sum of money is worth more now than the same sum of money in the future

  
• The principle of the time value of money means that it can grow only through investing so a delayed investment is a lost opportunity
• Formula for computing the time value of money


  Considers the amount of money, its future value, the amount it can earn, and the time frame

  
• For savings accounts


  The number of compounding periods is an important determinant
• Inflation


  Has a negative impact on the time value of money because your purchasing power decreases as prices rise
• Discounted cash flow analysis

  Helps to determine the value of an investment based on its future cash flows
• Present value of expected future cash flows

  Arrived at by using a projected discount rate
• If the DCF is higher than the current cost of the investment


  The opportunity could result in positive returns and may be worthwhile
• Weighted average cost of capital (WACC)

  Companies typically use it for the discount rate because it accounts for the rate of return expected by shareholders
• Disadvantage of DCF


  • Its reliance on estimations of future cash flows, which could prove inaccurate
• If the DCF value calculated is higher than the current cost of the investment


  The opportunity should be considered
• If the calculated DCF value is lower than the cost


  Then it may not be a good opportunity, or more research and analysis may be needed before moving forward with it
• To conduct a DCF analysis

  1. An investor must make estimates about future cash flows and the ending value of the investment, equipment, or other assets

  2. The investor must also determine an appropriate discount rate for the DCF model, which will vary depending on the project or investment under consideration
• If the investor cannot estimate future cash flows or the project is very complex

  • DCF will not have much value and alternative models should be employed
• For DCF analysis to be of value

  • Estimates used in the calculation must be as solid as possible
  • Badly estimated future cash flows that are too high can result in an investment that might not pay off enough in the future
  • If future cash flows are too low due to rough estimates, they can make an investment appear too costly, which could result in missed opportunities
• Calculating the DCF


  Forecast the expected cash flows from the investment

  2. Select a discount rate, typically based on the cost of financing the investment or the opportunity cost presented by alternative investments

  3. Discount the forecasted cash flows back to the present day, using a financial calculator, a spreadsheet, or a manual calculation
• Discounted Cash Flow Formula

  The formula used to calculate discounted cash flow