A BASIC METHODOLOGY FOR MEASURING VALUE
As we've enclosed, financial managers want to know how value is resolute for both financial possessions (such as stock and bond) and real property (such as projects, company units, or even whole organizations). In both cases, value depends straight on the cash flow the resources are probable to construct. The process of value stream of future cash flows is called discounted cash flow (DCF) analysis. The DCF methodology is an extensively used framework with various applications in business finance. Some common applications include estimating a rigid cost of capital, assessing the valuation effects of issue various types of securities, determining the value of new investment projects, and estimating the value of takeover goals.
The fundamental underlying justification for economical cash flow (DCF) analysis is the time value of money. A dollar in hand today is appeal more than a dollar due sometime in the prospect, because a dollar received today can be invest and thus be worth more than a dollar in the future. The DCF methodology tells a financial manager how much additional value would be gained or lost by altering the timing of cash flow from a speculation.
The definite procedure of drama a discounted cash flow analysis can be wrecked down into four steps.
1. Estimate the future cash flows. Estimating future cash flow for some resources, such as bonds, is rather easy. In that situation, since the asset's cash flows are contractually fixed, the promise flows will be realized unless the issuer defaults. Estimate cash flows for other classes of possessions can be tremendously complicated. This is because cash flows from other possessions are more difficult to approximation precisely. For example, when Microsoft decides to expand new software, it has to approximation research and expansion costs, and the future proceeds and operating cost cash flows, all over a multiple year project life. Cash flow estimation under such circumstances is clearly challenging, and highly precise forecasts are quite complex to come by.
2. Assess the riskiness of the flows. One particular scenario of the probable cash flows is frequently inadequate because of the intrinsic ambiguity in the cash flows. The financial manager therefore also wants to enumerate the quantity of risk in the predictable cash flows.
3. Incorporate the risk assessment into the analysis. The accomplish of risk on benefit values can be incorporated in the psychoanalysis in either of two traditions: (1) by the risk-adjusted discount rate (RADR) approach or (2) by the certainty equivalent (CE) approach In the CE approach, the predictable cash flows are condensed or familiar downward to account for jeopardy. The higher the risk of the project's cash flows, the inferior the risk-adjusted, or assurance correspondent, cash flow. In the RADR approach, the discount rate rather than the cash flow is adjusted for risk-the higher the risk of the project, the higher the discount rate. As a practical stuff, the risk- adjusted discount rate will reflect risk from two sources: the riskiness of the project's cash flows (business risk) and the financial risk fashioned by the way the project is funded (financial risk).
4. Find the present value of the flows. The final step is to find the current value of the cash flows. This step informs a financial manager about the probable value of a stream of opportunity cash flows in today's dollars. Thus, the progression of discounting eliminates the problem of compare cash flows that occur at various times in the future.
The theory of opportunity cost plays an imperative role in DCF analysis. To illustrate, assume a rigid retains all of its earnings from the preceding year, and is now evaluating numerous speculation alternatives. Should a cost be assigned to these retain income, or should the resources be precise as "free" capital? One line of analysis might propose that the resources have a zero cost-after all, the retained salary have no noticeable cost, since the firm already has access to those funds. However, a prospect cost must be assigned to each substitute. By investing the retained salary in one substitute, the firm forgoes the occasion to devote those funds in any other substitute. Moreover, the firm's shareholders have not been given the occasion to invest those funds else- where in option investments, since the firm retain all its salary rather than revisit them to shareholders as a cash dividend. Thus, there is a cost to the firm and its shareholders, and this cost should be included into the speculation analysis.
The discount rate functional in DCF asset analysis must reflect inevitable opportunity, but how does the financial executive choose which alternative should be careful? The apposite discount rate should reproduce the revisit that could be earned by invest the funds in the best option investment occasion of comparable risk. However, it may be very hard to estimate the proceeds accessible on comparable substitute real asset funds. When Microsoft was setting the occasion cost rate for its Windows 2000 investment, the most consistent choice was the arrival predictable on other new software savings. However, such information is hardly ever available, so the expected rates of revisit on financial possessions are typically used to set the occasion cost rate for all speculation decisions. For most projects, a rigid will determine its cost of capital, and use that rate as the occasion cost for many of its investment decisions. The cost of capital is basically a weighted average of the proceeds that investors anticipate to receive on its accessible set of financial securities. New projects that have risks very different from the firm's existing projects are often evaluated using more superior techniques, such as the method of comparables.
We see, then, that in any DCF examination it is necessary to allocate an opportunity cost discount rate. In general, that rate must reproduce the following three factors:
1. The riskiness of the cash flows. The discount rate must replicate the risk intrinsic in the cash flows-the higher the risk, the superior the discount rate. For illustration, the
discount rate used to appraise corporate bonds will be superior than that used to assess Treasury bonds, and the rate functional to cash flows from a firm's frequent stock (dividends plus capital gains) will be advanced than that practical to its bonds.
2. The prevailing level of rates of return. The discount rate must reproduce the existing level of proceeds in the financial system for the same period of time. Thus, in December 2001 the discount rate functional to cash flows have the identical level of risk as a 3-month Treasury bill was 1.61 percent, but in July 1996 the rate was only 5.3 percent. Because of changes in predictable inflation, in risk dislike, and in provide and demand conditions, the existing return on short term Treasury securities rose by 180 basis points in four years.
3. The timing of the cash flows. The final deliberation is the timing of the flows; that is, do the flows happen annually, periodical, or over some other period? In general, most analyses are conduct in terms of annual discount rates, and in many situations the cash flows do occur yearly. Under this situation, no adjustment to the annual discount rate is necessary. However, if the cash flows occur over some phase other than annually, say, semiannually, then the discount rate must be attuned to imitate this timing pattern.