Discounted Cash Flows: Finding Value……
Choosing Between Investment Options
February 12, 2018
Dr. Karen Smith Bogart

Today
•
Capital Budgeting
•
DCF
•
Assessing Value: 3 Approaches
•
Blood Analyzer Homework Assignment

Capital Budgeting
•
The future of a company lies in the investments it
makes today. Choices….
•
Investment project proposals are the responsibility
of all managers in the organization.
•
Capital budgeting is the financial evaluation of
project proposals.
•
Weigh $$$ outlay (investment) today vs. expected
future benefits.

Discounted Cash Flows
Approach to decision-making:
•
Discounted cash flow (DCF) analysis is the
backbone of modern financial analysis.
•
DCF is used to evaluate project-related cash flow streams
whose costs and/or benefits extend over multiple years.
•
A method to value a project, company or asset.
•
Used all the time in real estate, banking and corporate finance.

Discounted Cash Flows
Would you rather have $200 today or $200
in one year?
–
Assume there is no trick….
–
Why? Advantages? Risks?

Time Value of Money
•
Income today is real.
•
Income received in the future is worth less than
the same income received now.
•
Why? :
–
Risk
–
Inflation
–
Uncertainty
–
Missed opportunity to take, invest and earn interest.
–
Opportunity Cost: Could have invested in alternative
projects

Discount
(RISK) Rate
The discount rate reflects the risk associated
with the cash flows.
–
Many investors would rather have their cash now.
–
Investors want to be compensated for the delay.
–
A “risk premium” is added which reflects the extra return investors
demand due to their risk.
Impact of risk:
–
When the discount rate goes up: the present value goes down.
–
When the discount rate goes down: the present value goes up.
Predicting the future is risky…
–
Most discount rates include a “risk premium”
–
Higher the project risk, the higher the discount rate should be
•
Start-up biotechs:
30-40%
•
Expansion project for established company: 5-15%
Discount

DCF Concept and Steps
Concept
:
•
A valuation method used to estimate the attractiveness of an
investment opportunity.
•
DCF analysis uses future cash flow projections and
discounts them to arrive at a present value estimate which is
used to evaluate the potential for investment.
Steps
:
1.
Estimate the relevant cash flows.
2.
Calculate the rate of return for the investment.
3.
Compare the returns to your acceptance criterion.

Key Informational Needs
Information you need:
•
n = number of periods (time
)
•
i = interest rate
•
PV = present cash flows
•
PMT = annuity stream of cash flows
•
FV = future cash flow
****For ease, use a financial calculator phone app
(e.g. Ez Calculators)!

DCF Concept: Present Value
•
Present Value
:
The current worth of a future sum of money or stream of cash flows given a
specified rate of return.

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