Explain the theory of the discounted cash flow

Explain the theory of the discounted cash flow

Discounted cash flow (DCF) refers to the valuation method used in estimating the value of an investment using future cash flows. DCF method tries to figure out the company’s value at the moment while utilizing its future cash flows (Kruschwitz & Löffler, 2006). The present value estimate is then utilized in estimating the value of a potential investment. If the value estimated of the potential investment is higher than its implementation cost, the project should be considered. The reason for the DCF theory is an estimation of the amount an investor will gain from a project.  This is adjusted using the time value of money. The time value concept assumes that a dollar today is worth more than a dollar tomorrow. For instance, using a 6% annual interest, 1 dollar today in a savings account will be worth $1.06 after a year. Either, if a $1 payment is delayed for one year, its present value is $0.94 since it cannot be saved in a savings account.

Investors benefit from the DCF tool since it acts as a means of confirming the fair value of prices published by analysts. The method requires one to utilize various factors that affect a business venture in addition to profit margins and future growth in sales (Laurence, 2017). Besides, one takes into consideration the discount rate, which is influenced by a risk-free rate of interest, potential risks of the venture, and the cost of capital. This method enables one to gain insight into factors that affect prices in order to put an accurate price tag into the company’s stock.

DCF analysis is hard to utilize in moments when an investment is involved, large, or when the future cash flows cannot be accessed. The valuation of a private firm will majorly be based on cash flows that will be available to the new owners (Laurence, 2017). DCF method is also utilized with dividends paid to minority shareholders to publicly traded stocks indicates that the stock of reduced value. Either the theory is highly useful in the evaluation of individual projects or investments in which an investor or a firm can control or forecast useful a reasonable amount of confidence (Laurence, 2017). Besides, the analysis needs a discount rate that takes into account the time value of money and the return on the risk they are assuming. Based on the purpose of the investment, there are various ways of finding the correct discount rate. DCF is majorly utilized by accountants and bankers but not highly utilized by analysts.

Alternative approaches to DCF helps in the valuation because of its limitations; thus, care should be taken while using it in the assessment of absolute value. The implied market discount rate can be used since DCF uses three variables to find others, which are cash flows, value, and discount rate. Scenario analysis is another way of utilizing the DCF theory.

The practical use of DCF analysis for valuation is applicable available in several ways. First, DCF is calculated through the calculation of the cumulative present value of all future free cash flows (Kruschwitz & Löffler, 2006). Free cash flows mean that the cash flows used are after-tax and capital expenditure before dividends and interest is paid. Thus it is the cash flow available for equity holders and debt only. DCF value usually results in absolute value; thus, the issue of comparators is non-existent as it exists in other methods.

There are various areas the DCF method can be utilized. It can be applied to any company. However, there exist several practical challenges. First, it needs the cash flows to be forecast for an extended period. The method is challenging to apply if cash flows are highly cyclical, subject to dislocations, or volatile (Kruschwitz & Löffler, 2006). However, other techniques suffer from the same challenge; thus, DCF is by no means any worse compared to other methods, and it is by no means worse than the others. The technique is better than others since the analyst has to forecast the cash flow profile, thus addressing the strategic issues and the business the Company is involved in. The calculation of discounted value should use cash flow forecasts of five years, preferably. The use of terminal value can approximate the value which occurs beyond the forecast period.

Second report:

-Discuss quantitative and qualitative parameters considered in capital allocation (with examples)

Capital allocation refers strategic process used by organizations in making capital investment decisions. Well, performing organizations place critical emphasis on formal allocation of capital since they understand that the current capital capacity referred to as debt and capital, are functions of the past financial performance (Orsini, 2019). Poorly done financial decisions can lead to financial and market challenges that emerge three to five years later.

Every investor at least utilizes a little of both quantitative and qualitative methods. However, they may emphasize one or another. The qualitative method majorly considers the quality of the company. It majorly focuses on the company’s services, product competitors, and management (Orsini, 2019). Either, the critical focus is put on finding companies that have a sustainable competitive advantage. Also, it makes assumptions about the future using quality. The analyst uses qualitative aspects of the company in making prospects. For instance, the political approach utilizes qualitative parameters purely in capital allocation. The departments or the sections which demand the most get the most (Orsini, 2019). However, new projects do not always bring the best results. This approach assumes that the initiatives will produce results that will support other projects and ignores the quantitative approach.

History-based parameters are another approach in capital allocation in which capital is allocated the same way it was allocated in the previous years (Piacentino, 2019). For instance, if a department received X percent capital allocation for this year, it would expect to receive the same amount in the next period. The challenge, for instance, in health care set up, the environment is rapidly changing, and what brought positive results this year may not be as effective in the preceding year. Besides, focus on past performance may fail to be consistent with the current strategy.

The balanced scorecard is another approach that utilizes qualitative parameters in capital allocation. Parameters used here include management issues, physician satisfaction, market issues, and community needs. For example, if a project is designed to meet community needs, then the balanced scorecard will give it high marks.

The quantitative approach uses parameters like income statements, cash flows, and balance sheets in analyzing the relationship between price and intrinsic value. For instance, healthcare facility utilizes a quantitative approach of first come first served (Piacentino, 2019). Hospitals can use this method in resource allocation for some projects as they arise throughout the year. The organization has to go into detail by calculating cash flow, ready to be spent on projects. As the year goes on, capital is allocated to projects one by one against their calculated limit. However, as the year progresses, some best projects may lack the funds needed because they may come late.

The corporate finance method of capital allocation uses a quantitative method. It would quantify the possible impact associated with increased satisfaction (Piacentino, 2019). For instance, will increase satisfaction among physicians increased the effectiveness of using hospital services? If yes, what are the financial impacts to be expected? Indeed, the answers to these questions are fair estimates. However, even these estimations give the company’s capital allocation some potential to cling on. The method calls for quantification of the qualitative factors within an organization.

Rolling capital approach adopts a method used in operating budget management. The method would result in a capital spending plan which will reflect management priorities, short-term market reactions, and new technologies and operating performance (Piacentino, 2019). The method focuses on key quantitative parameters such as grouping capital projects into various portfolios. It might focus on financial margins, cost reduction, margins, and value. These aspects utilize different ways like a standardized decision-making approach, which is deemed a critical method in capital allocation. Project return focuses on cost reduction and value, which are some of the intents of a business. Lack of common return requirement undermines the integrity of the decision-making process.

Conclusion and recommendation:

-A conclusion about capital budgeting under uncertainty and capital rationing

Traditionally, a project’s value is determined using its net present value, which is equivalent to the total of discounted future cash flows reduced through the required initial investment. The assumption with this method is that the expected future flows and the discount rate are known while the project will start immediately (Meier et al. 2001). However, in reality, a project’s cash flows will be different from the expected ones initially.

Capital Budgeting under uncertainty

Indeed, we do not always know the outcome of most future events with certainty. One way of handling the problem is by using a probabilistic model that will describe the situation. This is highly useful in financial decisions where the future cash flows are not well known (Meier et al. 2001). A way of overcoming this uncertainty is through the development of a subjective probability distribution for different possible outcomes. In order to get the value of the uncertain outcome, the probability of the different possible outcomes is multiplied with the value for every outcome. Then one has to sum all the values. This can be expressed as an equation;

E(V) = å i=1 n PiVi

E(V) is the expected value of an uncertain outcome; P_i represents the probability that the outcome V_i will happen while n represents the total number of possible outcomes (Schwartz & Trigeorgis,2004). However, in case of a large number of independent observations for a random event, then the result may be approximated using a normal probability distribution. The two aspects used in the representation of mean distribution or the expected value for the µ variable as well as the standard deviation. In the case of a smooth bell-shaped curve, it will be used in the representation of probabilities. On the other hand, the area under the curve is a representation of the cumulative probability for the given outcome.

The risk-adjusted discount rate method is almost the same as the NPV method. It is viewed as the mean value of the future cash flows (Crum & Derkinderen, 2012). The discounting rate used takes into account the risk premium of the cash flows of the project. On the other hand, a certainty equivalent method adjusts risk through the expected value of the cash flow for every period. It then discounts the risk-adjusted cash flows via a risk-free interest rate. Also, a decision tree is used, which helps in the analysis of opportunities that involve several decisions over time.

Capital rationing refers to the method of putting restrictions on the number of new projects or investments to be undertaken by a company (Brüggen & Luft, 2011). This is achieved by having a higher cost of capital for an investment decision or by putting a ceiling on given budgets. Companies may choose to implement capital rationing in areas where past returns from investments were lower than expected. A company goes for projects which have the highest total NPV. In capital budgeting, a company’s priority is not to over-invest in assets.

Various methods can be used in making capital budgeting decisions under capital rationing. In times when initial outlays happen in two or more periods, the methods are somehow elaborate and call for integer, linear, or goal programming (Kachani & Langella, 2005). However, in times of a single time capital budgeting aspect, a simple method of profitability index is used. The method contains these steps;

For the investment projects, calculate the profitability index,

Rank the projects from highest to the lowest using their profitability indexes. Right from the project with the highest profitability index, choose the projects whose profitability index is higher than or equal to 1.

Recommendations

• An excellent capital rationing method in place helps the financial health of a company in the long run
• A company should consider rationing its capital in order to invest in various projects efficiently thus increasing dividends

References

Meier, H., Christofides, N., & Salkin, G. (2001). Capital budgeting under uncertainty—an integrated approach using contingent claims analysis and integer programming. Operations Research, 49(2), 196-206.

Schwartz, E. S., & Trigeorgis, L. (Eds.). (2004). Real options and investment under uncertainty: classical readings and recent contributions. MIT press.

Crum, R. L., & Derkinderen, F. G. (2012). Capital budgeting under conditions of uncertainty (Vol. 5). Springer Science & Business Media.

Brüggen, A., & Luft, J. (2011). Capital rationing, competition, and misrepresentation in budget forecasts. Accounting, Organizations, and Society, 36(7), 399-411.

Kachani, S., & Langella, J. (2005). A robust optimization approach to capital rationing and capital budgeting. The Engineering Economist, 50(3), 195-229.

Kruschwitz, L., & Löffler, A. (2006). Discounted Cash Flow.: A Theory of the Valuation of Firms. John Wiley & Sons.

Laurence, P. (2017). Quantitative modeling of derivative securities: from theory to practice. Routledge.

Orsini, J. N. (2019). Applied Quantitative Finance.

Piacentino, G. (2019). Venture capital and capital allocation. The Journal of Finance, 74(3), 1261-1314.