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The Discounted Cash Flow Techniques in Making Investment Decisions

Cash flows refer to the cash inflow and outflow of a business. When the time factor is introduced and the future amounts brought to an equivalent present amount, the cash flows are said to be discounted. This is achieved by the use of an appropriate discounting rate that is often pegged at the inflation rate (Horngren and Walter 2007).

Most investment decisions are made for the long term and every investor is concerned about the grace period before the breakeven point and the initial investment. No matter how lucrative an investment may seem to be, there are unforeseen factors that are bound to dictate the kind of returns realized by the investors (Larrabee and Voss, 2012). Discounted cash flows allow investors to be pessimistic to the highest possible sense to determine the suitability of an investment. For instance, if an investor is pessimistic about an investment he can determine its suitability by increasing the discounting rate. An investment whose net present value is negative implies that the investor would end up making a loss. Therefore, discounted cash flows are important in evaluating a particular investment.

For instance, an investor might come across a venture with the following cash flows. Assume the discount rate is 7%.

Year Cash flow
0 (500,000)
1 10,000
2 20,000
3 100,000
4 250,000
5 130,000

This implies that the discounted cash flows can be calculated as follows.

Year Cash flow PVF (7%) Discounted cash flow
0 (500,000) 1 (500,000)
1 10,000 0.9346 9346
2 20,000 0.8734 17468
3 100,000 0.8163 81630
4 250,000 0.7629 190,725
5 130,000 .7130 92690

Therefore, the NPV based on the discounted cash flows is:

(9346+17468+81630+190,725+92690)- 500,000 = -108141

Since the Net Present Value of the investment is negative, then the investment should not be pursued.

Once in a while, an investor is faced with several options in which he/she can invest his money. Discounted cash flows techniques help evaluate the most viable option to pursue. For instance, projects with the highest net present value (NPV) should be chosen over those with a low net present value (Warren, Reeve, Duchac 2011). Projects with a higher NPV imply the investment is bound to realize more returns sooner than all the other projects.

For instance, an investor may have the chance and resources to invest in only one of the three different investments at his disposal. Investment A would require an initial cash outlay of $100,000; B would require $ 150,000 while investment C would require $ 250,000. The cash flows from all three investments are as below. The return on capital is 7%

Year Investment A Investment B Investment C
1 10,000 20,000 50,000
2 5,000 50,000 40,000
3 20,000 100,000 30,000
4 50,000 40,000 50,000

These cash flows can be discounted as follows:

Year PVF Discounted cash flows(A) Discounted cash flows(B) Discounted cash flows(C)
1 0.9346 9346 18692 46730
2 0.8734 4347 43670 34936
1003 0.8163 16326 81630 24489
4 0.7629 38145 30516 38145
  • The NPV for A: = 68124-100,000 = -31836
  • The N. P. V for B: =174508-150,000 = 24, 508
  • The N.PV for C: =144300- 250000 =-105, 700

From the above, all the projects have a negative NPV value except project B, whose present value is 24,508. This implies that among all the choices that the investor has, the most appropriate choice is B.

The profitability ratios entail all the ratios within the income statement that include the sales, cost of goods, gross profit, other expenses, and net profit. The shown income statements provide some incites on the same as discussed below.

The gross profit margin: under this heading, it is clearly shown that from the companies’ performances, it is clear that the companies cost of goods is too high in this industry since, in the overall overview of all the companies, there is no company with above 50 % of the gross profit. Though the above holds, company C with 40 % outperformed the other companies in the industry followed by company B with 22 % and lastly company A with 15 % (Hansen and Mowen, 2006).

The key reason that company C may be exploiting to enhance this is by minimizing the cost of goods since the cost of goods plus gross profit is equal to sales made during that period. Consequently, it cannot be clearly said that company C outshines the others since the range of costs that will lead to the net profit are yet to be deducted (Davis and Davis, 2011).

Conclusively, this cannot make a general ruling that company C is the best in the industry, thus, the following discussion will be taken into consideration before the final ruling over profitability is stated.

The net profit: this is another consideration where the companies’ net income is being considered after all the deductions have been made. Under this heading, company C continues to lead with 12 % followed by company B with 10 % company The following suits with 9 %. Under this heading, it shows that the companies’ expenses need to be discussed closely looking at what percentage takes the sales.

The companies’ expenses will be analyzed from their net profit minus the gross profit (Belkaoui, 2003). In this analysis, company C leads with the highest cost of expenses which is 28 % followed by company B which uses 12 % in meeting the administration costs and other related costs while company A uses 6 % of its sales to meet the above-said expenses.

As it can be shown from the figures the companies’ profit is the remnant of the expenses met by the company in hand (Warren, Reeve, Duchac 2011). The highest expenses that are met by the respective companies go to company A thus giving an inference that, though company A may have the highest market share, it is highly insensitive to the expenses it meets since it is fetching very low profit from its operations.

The next company that needs to have a lot of consideration on its expenses is company B which has a 90 % level of sales meeting the same followed by company C which has an 88 % (Gernon and Meek, 2000). On a close look, it shows that for average industry profitability the companies in this economy are supposed to have around 88 % of the sales to meet the expenses thus company A can be said to underperform since a net profit of 9 % is highly questionable because it is even below the industry’s profit.

Conclusively, company C is an all-around cost minimizer since on average it is the company with the lowest expenses but if it does something on the other costs apart from the cost of goods the profitability will rise very high in the industry. Company B also can upgrade its profitability by trying to minimize its cost of goods since that is the area that makes it underperform compared to company C. Lastly, company A needs to consider the costs of goods closely since it is expensive that makes it underperform compared to all the others. It is highly commendable to say company A has a future in the industry since where the other companies are overusing funds it has marginally reduced hence showing potential growth in the future since they need to understand how to minimize the cost of goods sold.

The next area of analysis is the working capital, where working capital is the summation of the current assets less current liabilities (Damodaran, 2008). Therefore, from that mathematical definition, anything that runs around current assets and current liabilities will be the point of analysis. The discussion of this is following:

The stock days: these are the number of days the inventory of a company stays before depletion. The faster the depletion rate of inventory/ stock, the better since the longer the period the higher the tying up of the ease of liquidity of a company (Kruschwitz and Loeffler 2006). Company A, in this case, is the best company that can meet its current liabilities since it only holds its stock for a very short period compared to company B and C respectively thus it insinuates that company A is highly minimized to hold on inventory for longer than any other company.

Debtors’ days: this is another working capital consideration in this industry. From the close analysis of this, company A carries the day since it does not attract bad debts, and also it helps the company be able to meet its current liabilities very fast. This suggests that company A’s current assets are always held in cash form but no other means. Therefore, company A’s liquidity tends to be very high compared to the others. Company B follows and company C closes the chapter.

Creditors’ days: this is another category of the working capital that the company needs to address since to some extent this is a source of funds for investment but when not properly managed it can cause issues with the supplies especially to such an industry (Eisen, 2007). In response to the figures stated, company A creates the best reputation for the supplies thus company A will always fetch what they deserve from them, followed by company B and lastly company C. From a financial analyst’s view, company B has the best working capital since it is the company with minimum debts financed by category. In addition to this, company A will follow, and lastly company C (Periasamy, 2009).

Conclusively, company A has the best working capital followed by company B and lastly company C only by looking closely at the paying back periods of the debtors and creditors, the retention rate of inventory and the changes of the return on capital employed, and the return on shareholders’ funds (Jenkins 2008).

The investment ratio analysis on investors: This is another point to consider before investing in any company since rational investors have some factors to consider, such as the level of EPS, P/E, investment ratio, and lastly dividend ratio. Under this consideration, the following are the points to pay attention to (Kimmel, Weygrandt, and Kieso 2010):

The level of EPS: from this analytical view, company C with 25p followed by company B with 20p and company A with 15p will follow the order of priority in investing in them but this is not conclusive thus the following still have to be discussed.

Price per earnings ratio: this is another consideration where company C with 29 becomes the best company to invest in since the higher the ratio the better the company to invest in followed by company A with 15 and lastly company B with 12.

Investment ratio: this analyses the returns to {assets, capital employed, or shareholders’ equity invested} relationship (Jiambalvo, 2009). From the close view of both the return on capital and the return on shareholders’ funds, it shows that the best company to invest in is company B since it is the one with minimum risk of being taken by the creditors followed by company C and lastly company A. To those investors who are risk averters, it is necessary to take company B but those who are risk-takers, – company A.

Lastly, let us consider the dividend ratio. This is the ratio with which the company pays out its profit in terms of dividends to the shareholders (Balakrishnan, Sivaramakrishnan, and Sprinkle 2008). Company B carries the day since from its dividend pay-out ratio, it has the best of 89 % followed by company C with 80 % and lastly company A with 67 %.

Generally and conclusively, company B in terms of this analysis will be the best to invest in, since it has minimum risk with a high pay-out ratio and relatively high P/E ratio.

List of References

Balakrishnan Ramji BK, Sivaramakrishnan K & Sprinkle G 2008, Managerial Accounting, John Wiley & Sons, New Jersey.

Belkaoui AR 2003, Accounting: By Principle Or Design? Greenwood Publishing Group, Hartford.

Davis CE & Davis E 2011, Managerial Accounting, John Wiley & Sons, New Jersey.

Damodaran, A 2008, Strategic risk taking: a framework for risk management, Pearson Prentice Hall, New York.

Eisen, MG 2007, Accounting, Barron’s Educational Series, New York.

Gernon HM & Meek GK 2000, Accounting: An International Perspective, Irwin, New York.

Hansen DR & Mowen M 2006, Managerial Accounting, Cengage Learning, New York.

Horngren, CT & Walter, TH 2007, Accounting, Prentice Hall, Ohia.

Jenkins G 2008, Managerial Accounting: A Focus on Ethical Decision Making, Cengage Learning, New York.

Jiambalvo J 2009, Managerial Accounting, John Wiley & Sons, New Jersey.

Kruschwitz L & Loeffler A 2006, Discounted Cash Flow: A Theory of the Valuation of Firms, John Wiley & Sons, New Jersey.

Kimmel PD, Weygrandt J & Kieso DE 2010, Accounting: Tools for Business Decision Makers, John Wiley & Sons, New Jersey.

Larrabee DT & Voss JA 2012, Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options, John Wiley & Sons, New Jersey.

Periasamy, WC 2009, Financial Management, Tata McGraw-Hill Education, New York.

Warren C, Reeve J & Duchac J 2011, Accounting, Cengage Learning, New York.