Discounted Cash Flows

Discounted Cash Flows – Capital Budgeting Techniques

We have discussed earlier that accounting rate of return & payback period ignores time value of money and cash flow trends. Means cash inflow of $5000 in the first year and $50 in the fifth year is just as good as $50 in the first year and $5000 in the third year. Payback period technique ignores all cash flows after recovery of initial investment.

Investors who are not familiar with the discounted cash flows method are usually relying primarily on payback period technique. Therefore, they come up with biased decisions like projects with earlier returns are preferred over those that promise later returns. Seasoned investors consider the factor of the time value of money and choose those Capital Budgeting Techniques that involve discounted cash flows while analyzing their investments.

Discounted cash flows

Discounted cash flows use required rate of return, least acceptable annual rate of return on an investment. Means investors will invest their money in a project only if their required rate of return is equal to or greater than the cost of capital.

If you have won a prize and you have been offered to receive $5000 now or $5000 in two years. Which option would you go for?

Obviously, you would prefer to receive $5000 now rather deferring your payment for two years. Time value of money concept demonstrates that a dollar today is better than a dollar a year later. Common sense says that all things being same it is better to have money now than then.  You can do much more things with $5000 if you have it now. For example, you can invest that money somewhere and can get a handsome return on your investment over a period of time.

Discounted Cash Flow Analysis

Let’s start with a question. How should we make financial decisions? Well, a reasonable answer might be to undertake those actions that create value. Value for those affected by the decision, value for the owners of a firm for example.

Which actions create value? And while that’s a complicated question, a sort of general answer that seems reasonable would be to consider actions in which the benefits exceed the costs. But here’s a little wrinkle, what if the costs and benefits arrive at different times? Well actually, we are well equipped to deal with that wrinkle because we can compare the present value of the benefits to the present value of the costs. See, because by computing the present value we know that the discount rate, R, will adjust for both the timing and the risk of the cash flows. So that brings us to our first lesson, which is that the NPV Decision Rule, that is NPV which stands for Net Present Value.

NPV. The NPV decision rule says that we should accept all projects with a positive NPV and reject all projects with a negative NPV.

Where NPV is nothing more than the difference between the present value of the benefits and the present value of the cost. In other words, if the present value of the benefits is bigger than the present value of the cost, that is a good thing, that creates value. And we want to undertake that project or make that decision that leads to positive NPV. And while this formula right here looks somewhat vague and ambiguous, it’s actually masking something that we are already very familiar with, and that’s just discounted cash flows. NPV is nothing more than discounted cash flows, except now instead of cash flow CF, I have this F in front of all the cash flows. So it’s FCF. The F simply stands for free.

So these are free cash flows, but they’re still just cash flows nonetheless. There is nothing special there. I’m going to formally define and discuss how to compute free cash flows in our next lecture, but for the time being, just recognize we’re doing nothing new here. We are simply taking a stream of cash flows, FCF naught, FCF 1 through FCF T, and we are discounting them back to today, by a discount rate R, to get a present value, a net present value.

That’s it. And so the decision rule just says if the NPV is greater than 0, accept the project. If the NPV is less than 0, reject the project. Sorry, reject the project. And while that seems fairly easy and straightforward, actually implementing it is quite a bit more subtle. And we’re going to talk about those subtleties as we move along, throughout this topic.

So, before moving on to some of the mechanics of a DCF analysis, I want to talk about decision making in practice briefly. Because it’s useful to motivate it and to understand what people in different areas of both finance and non-financial sectors are doing when they’re making decisions. So the first thing I want to look at is this, or show you, is this survey evidence from a survey by John Graham and Cam Harvey, former colleagues at Duke, in which they surveyed CFOs from the Fortune 500 and other US domestic firms. And they asked them, how frequently do you use capital budgeting, different capital budgeting techniques.

And what you can see is that there are actually a variety of responses. I have listed six here. But the majority or the predominant number of responses point to net present value and internal rate of return as the most popular decision criteria that CFOs use. That is followed somewhat closely by the payback rule, and to a lesser extent, the discounted payback rule. In our discussion of DCF, while NPV is going to be center stage, we are actually going to spend a fair amount of time discussing all of these decision rules. Because each one actually has important information for the decision-making process, though each one also has certain limitations that we need to understand.

Now that is in the non-financial corporate sector. If we look at what investment bankers do when they are valuing companies in fairness opinions, you can see that the large majority of investment bankers are also relying on discounted cash flow analysis, something akin to NPV.

But they’re also using a host of comparable methods or relying on multiples. And while this is going to take us a little bit outside of the scope of our course I might mention, if we have some time, how we use multiples in valuation exercises. If not, I might post some additional material.

And finally, there’s a recent survey by Paul Gompers, Steve Kaplan, and Vladimir Mukharlyamov. I hope I am not butchering that name too poorly. But they have a really interesting survey of private equity firms in which they investigate, among many things, which criterion PE investors used to evaluate an investment. And what’s interesting here is the vast majority rely on the internal rate of return, by a wide margin, over any other criterion.

So let us summarize this.

So we’re going to move through this topic of DCF, discounted cash flow, emphasizing to a certain extent the NPV rule, because that is the optimal rule in terms of always leading you to make the decision that creates value. That said, I am going to take a much more practical perspective to corporate decision-making, or financial decision making more broadly, and recognize that other rules are still informative. They are still useful. So it is not surprising that we see their use by practitioners, whether it is PE, private equity investors, or investment bankers, or CFOs. They’re still informative, but the important thing to keep in mind is that these other rules have certain weaknesses that we need to understand and we need to recognize the limitations of these rules so that we can use multiple rules in conjunction to come to the best decision.

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