–Opportunity Cost: Could have invested in alternative projects
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. •To compute the PV of money you’ll receive some years from now, a discount rate is applied –PV = FV/(1+i)n–If someone offered you $500 today or $1000 in ten years, and inflation is 3%, which would you take? –What if inflation rate is 1%? Or 8%? Future cash flows are discounted at the discount rate: - Reflects time value of money, risk or uncertainty of future cash flows - More uncertainty of cash flows: the higher the discount rate and lower the PV of future cash flows
DCF Concept: Future Value Future Value: The value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today. •Most common application is compounding: –The Future Value of money you have today at an interest rate –FV = PV x (1+i)n (i = interest rate, n = # periods)–Example: $1000 invested today, Interest rate = 10%, Time = 5 years would have a Future Value of $1,611.00.
Net Present Value (NPV) •Investing money now for a future payback involves risk •Alternative projects might provide a better return •NPV is the gold standard for getting the answers; it measures value creation •NPV is the PV of the expected cash flows minus the initial investment •Positive NPV= Expected payback is greater than the cost of doing it, accounting for time and risk
DCF Steps: Steps: 1.Estimate the relevant cash flows. 2.Calculate the rate of return for the investment. 3.Compare the returns to your acceptance criterion. But: 1.Step #1 is challenging. 2.Doing it well requires a thorough understanding of the company’s markets, competitive position, and long-run intentions. 3.Potential estimation difficulties arise with financing costs, working capital investments, shared resources, excess capacity, contingent opportunities, etc….
Next Class: January 30, 2019 •Readings for this Class: –Higgins, R. (2007). Analysis for Financial Management. Chapter 7•Homework Due: –1/30: Blood Analyzer: On Gauchospace Course Website Reminder: Practice Round Deadlines: •Monday, 2/4 CAPSIM Introduction: —Read CAPSIM Manual & do Tutorial beforeclass! •Tuesday, 2/5 by 11PM PT: Practice Round 1 •Thursday, 2/7 by 11PM PT: Practice Round 2 •Sunday, 2/10 by 11PM PT: Practice Round 3