FREE DCF Analysis Question and Answers
- Simplicity - easy to calculate, easy to understand
- Screening Investment projects - provides a tool for rough screening of investment proposals
- Risk of project - provides insight into risk of the project - earlier cash flows are considered more certain that later years.
While the Payback Method offers simplicity and a quick assessment of investment liquidity and risk, it falls short in providing a comprehensive analysis of project profitability and value creation over time. For more robust investment evaluations, discounted cash flow methods such as Net Present Value (NPV) and Internal Rate of Return (IRR) are typically preferred as they account for the time value of money and consider all cash flows throughout the project's life.
Concept that if offered 1 dollar today or 1 dollar in 1 year most people will take the 1 dollar today. Time value of money is the value of the dollar that could be earned in 1 year.
DCF Analysis "discounts" the cash flows of future years to make them equivalent to those in the current year
The Time Value of Money is a fundamental financial concept that recognizes the importance of timing and interest rates in assessing the value of money over time. It underpins various financial calculations and investment decisions, enabling more informed and strategic financial planning.
Payback Method Limitations
While the Payback Method offers simplicity and a straightforward approach to evaluating investment projects, its limitations regarding the time value of money and consideration of future cash flows can lead to incomplete and potentially misleading investment decisions. As a result, more sophisticated capital budgeting techniques like the Net Present Value (NPV) method or Internal Rate of Return (IRR) method are often preferred for comprehensive investment analysis.
Tangible - Physical / Real can be readily measured and quantified e.g Inventory reduction, overtime reduction, direct materials reduction
Intangible - Harder to quantify e.g increased flexibility, reduced lead time, greater reduction of throughput
Tangible and Intangible benefits of technology investment would focus on defining tangible benefits as measurable cost savings (e.g., inventory reduction, overtime reduction) and intangible benefits as non-measurable advantages (e.g., increased flexibility, reduced lead time) resulting from technology investments.
Discounted cash flow analysis
Discounted Cash Flow (DCF) analysis is a powerful financial tool that adjusts for the time value of money, providing a comprehensive evaluation of investment projects. However, it requires careful consideration of assumptions, discount rates, and cash flow estimations to ensure accurate and meaningful results.
Which of the following provides a gauge of a company's efficiency in managing the collection of its accounts receivable?
Days Sales Outstanding (DSO) specifically focuses on accounts receivable and provides insight into a company's effectiveness in collecting payments from customers. A lower DSO generally indicates better efficiency in accounts receivable management.
- unrealistic status quo
- Hurdle (discount) rates are to high
- Time horizons are to narrow
- difficulty of gaining approval for large projects
- exclusion of benefits that are difficult to quantify
- greater uncertainty about operating cash flows of new untested technology investments
Discounted Cash Flow (DCF) analysis limitations would highlight factors such as unrealistic status quo assumptions, high hurdle rates, narrow time horizons, challenges in gaining project approval, exclusion of difficult-to-quantify benefits, and increased uncertainty with new technology investments, all of which can impact the accuracy and reliability of DCF analysis outcomes.
- reinvestment assumption that cash flows be reinvested
- Year end timing of cash flows - NPV and IRR both assume and are treated as though they occue at year end. The error introduced is generally not large enough to cause concern
- Certainty of cash flows - DCF Analysis treats the cash flow associated with an investment project as if they are known with certainty. Risk adjustments can be made under NPV analysis to help account for cash flow uncertainty
Assumptions underlying Discounted Cash Flows (DCF) analysis would highlight the reinvestment assumption, year-end timing of cash flows, and the treatment of cash flows as certain or known. These assumptions are fundamental to DCF analysis but may not always perfectly reflect real-world conditions, requiring adjustments and considerations for risk and uncertainty.
Calculates payback period of investment. Calculate amount of time for cash inflows to accumulate to an amount that covers original investment.
payback period = Initial investment / annual cash flows
Payback period basic calculation will not work for projects with uneven cash flows ( have to manually calculate accumulated cash flows to find payback period
The payback method is a simple technique that calculates the time required for an investment project to recover its initial cost based on cumulative cash inflows. It is useful for assessing liquidity and risk but does not account for the time value of money or cash flows beyond the payback period.
- both methods will usually support or not support the proposal
FOR NPV
- NPV is easier to calculate - can use spreadsheet or calculator
- Can adjust for risk - for later cash floes by adjusting the discount rate
- NPV yields one answer - IRR can be calculated more than once where NPV is either positive or negative over cash flow periods
-NPV makes a more realistic assumption that cash flows are reinvested at firms required rate of return - IRR assumes investment at the projects rate of return.
- Ranking of projects under IRR can lead to sub optimal decisions
NPC is usually regarded superior to IRR when evaluating capital investment proposal
NPV vs. IRR would highlight NPV's advantages in ease of calculation, risk adjustment capability, single result interpretation, realistic reinvestment assumption, and superior project ranking compared to IRR. NPV is generally regarded as the preferred method for evaluating capital investment proposals due to its clarity and alignment with financial principles.
Calculates the present value of future cash floes of a project - Four steps needed to complete a NPV analysis of a investment proposal.
1. Prepare table showing cash flows during each year
2.Calculate present value of each cash flow using the required rate of return
3.Calculate NPV = sum of present values of the cash flows in each period
4.NPV if positive means project is acceptable on financial grounds, higher NPV more acceptable the project. Other strategic and quantitative issues need to be considered in decision
Discounted Cash Flow (DCF) analysis, particularly the Net Present Value (NPV) method, is a powerful tool for evaluating investment opportunities by quantifying future cash flows in present value terms. While NPV provides a robust financial basis for decision-making, it should be complemented with strategic and qualitative considerations to ensure comprehensive investment analysis.