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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