Introduction to Common Capital Investment Valuation Techniques Finance Essay

Every profit-oriented company faces the inevitable questions, whether to invest in long-term, short-term assets or in a project or not and which project is more profitable to invest in. These questions lead the potential investor to the necessity of investment valuation and investment comparison. Generally speaking the objectives of such valuation are to measure the expenditures and probable profits of the particular investment and its alternatives, choose one or a combination and make the most suitable with regard to company's strategic goals and financial situation decision.

The practice of Discounted Cash Flow method is based on a concept of Net Present Value. Which is the difference between the Present Value of future cash flows and the initial investment required to undertake a project. [Corporate Finance p. 13] it measures the excess or shortfall of cash flows, in present value terms, once financing charges are met.

NPV method computes Present Value of all expected future cash flows using a minimum desired rate of return. Discount rate of return depends on the risk of a proposed project - the higher the risk the higher the rate. Net Present Value is calculated with accordance to the following formula:

NPV

Where I0 - is the initial investment, CF - is a cash flow, n - is a project expected life, t - is a period respective to cash inflow, r - is the discount rate appropriate given the riskiness of the cash flow and t is the life of the asset.

Net Present Value provides an understanding of cash flows amount in present value terms upon the fulfillment of the project. Net Present Value is determined by income amounts, payback time (Discounting reduces the value of future cash flows to a present value equivalent and so is clearly concerned with the timing of the cash flows.) & discount rate.

traditional valuation methodology relying on a discounted cash flow. IRR,

Advantages and disadvantages

This chapter is dedicated to more detailed analysis of the various investment valuation methods, disclosing their positive and negative sides in terms of reflecting the reality and way of application.

One of the major disadvantages of all the theoretical methods is their assumptions. The nature and number of assumptions are the factors that define the practical effectives of a theoretical method.

As in the previous chapter Discounted Cash Flow is the first to be discussed.

Many analysts share the same opinion, that in many instances Discounted Cash Flow DCF method does not capture the realistic valuation of an investment. "All or nothing strategy" [Mun.p.57], what actually means that Discounted Cash flow exclude management flexibility from the valuation. Other disadvantages of the method are presented here.

Disadvantages and difficulties of Discounted Cash Flow method.

Discounted Cash Flow method doesn't take into consideration the uncertainty and variability of future outcomes. The assumption is that cash inflows and outflows are fixed and can't be changed within the lifetime of a project, but in real world outcome is probabilistic, rather than deterministic. However, the

actual business environment is highly fluid, and if management has the flexibility

to make appropriate changes when conditions differ, then there is

indeed value in flexibility, a value that will be grossly underestimated using

a discounted cash flow model.

This assumption leads us to the next problem, how to calculate cash flows as accurate as possible?

Another assumption implies that future cash flows are easy to calculate. When in reality it is actually quite a task to make accurate predictions about cash inflows and outflows as they are subject to changes as well as different types of risks.

Herein lies another problem: forecasting

the relevant free cash flows and deciding if they should be discounted

on a continuous basis or a discrete basis, versus using end-of-year or midyear

conventions. Free cash flows should be net of taxes, with the relevant

noncash expenses added back.5 Because free cash flows are generally calculated

starting with revenues and proceeding through direct cost of goods

sold, operating expenses, depreciation expenses, interest payments, taxes,

and so forth, there is certainly room for mistakes to compound over time.

A

recommended method is not to create single-point estimates of cash flows at

certain time periods but to use Monte Carlo simulation and assess the relevant

probabilities of cash flow events. In addition, because cash flows in

the distant future are certainly riskier than in the near future, the relevant

discount rate should also change to reflect this. Instead of using a single discount

rate for all future cash flow events, the discount rate should incorporate

the changing risk structure of cash flows over time. This can be done

by either weighing the cash flow streams' probabilistic risks (standard deviations

of forecast distributions) or using a stepwise technique of adding the

maturity risk premium inherent in U.S. Treasury securities at different maturity

periods. This bootstrapping approach allows the analyst to incorporate

what the market experts predict the future market risk structure looks like.

Finally, the issue of terminal value is of major concern for anyone using

a discounted cash flow model.

Several methods of calculating terminal values

exist, such as the Gordon constant growth model (GGM), zero growth

perpetuity consul, and the supernormal growth models. The GGM is the most

widely used, where at the end of a series of forecast cash flows, the GGM

assumes that cash flow growth will be constant through perpetuity. The GGM

is calculated as the free cash flow at the end of the forecast period multiplied

by a relative growth rate, divided by the discount rate less the long-term

growth rate. Shown in Figure 2.2, we see that the GGM breaks down when

the long-term growth rate exceeds the discount rate. This growth rate is also

assumed to be fixed, and the entire terminal value is highly sensitive to this

growth rate assumption. In the end, the value calculated is highly suspect

because a small difference in growth rates will mean a significant fluctuation

Traditional Valuation Approaches 63

in value. Perhaps a better method is to assume some type of growth curve in

the free cash flow series. These growth curves can be obtained through some

basic time-series analysis as well as using more advanced assumptions in

stochastic modeling. Nonetheless, we see that even a well-known, generally

accepted and applied discounted cash flow model has significant analytical

restrictions and problems. These problems are rather significant and can compound

over time, creating misleading results.

It is as well assumed that management makes all the decisions at the beginning and sticks to them during the whole time.

As it has been already mentioned cash flows are subject to different risks, which management should account for. The issue of risk is reflected in the equation of Net Present Value with the help of r (discount factor), but again it is assumed that there is only one source of risk, and it remains the same within the lifetime of s project.

The problem of risk recognition, i.e. of discount factor is one of the central issues in DCF method. The crucial question is how to calculate the most appropriate discount rate?

First of all it is important to differentiate the types of risks invilved. Prasan and Chandra [Project Valuation Using Real Options p.38] point out two types of risk: market risk and private risk.

Market risk reflects market-driven factors, which can affect the outcome of a project, when private risk relates more to managerial issues. According to Prasan and Chandra the necessity of differentiation of these types of risks is explained by the fact, that investor doesn't consider private risk at all while estimating the risk premium he is ready to pay.

According to Mun here are several models, which are used in order to calculate discount rate: Weighted Average Cost of Capital (WACC), Capital Asset-Pricing Model (CAPM), Multifactor Asset-Pricing Model (MAPT), Arbitrage Pricing Theory (APT).

WACC - calculation of a firm's cost of capital in which each category of capital is proportionately weighted.

The discount rate that is used is usually calculated from a WACC, capital asset-pricing model (CAPM), multifactor asset-pricing model (MAPT), or arbitrage pricing theory (APT), set by management as a requirement for the firm, or as a hurdle rate for specific projects.2

To determine an appropriate discount rate for valuing cashflows, a manager is confronted by

three major problems: the risk premium must be estimated, an appropriate risk-free rate

must be chosen (which reflects time value of money) and the beta of the project or company must be determined.In most circumstances, if we

were to perform a simple discounted cash flow model, the most sensitive

variable is usually the discount rate. The discount rate is also the most difficult

variable to correctly quantify. Hence, this leaves the discount rate

open to potential abuse and subjective manipulation. A target NPV value can be obtained by simply massaging the discount rate to a suitable level. In

addition, certain input assumptions required to calculate the discount rate

are also subject to question. For instance, in the WACC, the input for cost

of common equity is usually derived using some form of the CAPM. In the

CAPM, the infamous beta (_) is extremely difficult to calculate. In financial

assets, we can obtain beta through a calculation of the covariance

between a firm's stock prices and the market portfolio, divided by the variance

of the market portfolio. Beta is then a sensitivity factor measuring the

co-movements of a firm's equity prices with respect to the market. The

problem is that equity prices change every few minutes! Depending on the

time frame used for the calculation, beta may fluctuate wildly. In addition,

for non-traded physical assets, we cannot reasonably calculate beta this way.

Using a firm's tradable financial assets' beta as a proxy for the beta on a

project within a firm that has many other projects is ill-advised.

Secondly, discount rate depends on the magnitude of risk expected.

At last A standard dividend discount model cannot handle dynamic betas, risk premiums

or risk-free rates because, in this valuation method, future expected cashflows are valued at

constant discount rates.

Depending on the aim of DCF method application r could be calculated as Weighted Average Cost of Capital (WACC) or risk free rate or

Certain problems arise from the above mentioned assumptions.

Projects are "mini firms," and they are interchangeable with whole firms.

With the inclusion of network effects, diversification, interdependencies, and synergy, firms are portfolios of projects and their resulting cash flows. Sometimes projects cannot be evaluated as stand-alone cash flows.

Project discount rate used is the opportunity cost of capital, which is proportional to non-diversifiable risk.

There are multiple sources of business risks with different characteristics, and some are diversifiable across projects or time.

All factors that could affect the outcome of the project and value to the investors are reflected in the DCF model through the NPV or IRR.

Because of project complexity and so-called externalities, it may be difficult or impossible to quantify all factors in terms of incremental cash flows. Distributed, unplanned outcomes (e.g., strategic vision and entrepreneurial activity) can be significant and strategically important.

Unknown, intangible, or immeasurable factors are valued at zero.

Many of the important benefits are intangible assets or qualitative strategic positions.

Traditional methods assume that the investment is an all-or-

nothing strategy and do not account for managerial flexibility that exists

such that management can alter the course of an investment over time when

certain aspects of the project's uncertainty become known.

There are several potential problem areas in using a traditional discounted

cash flow calculation on strategic optionalities. These problems

include undervaluing an asset that currently produces little or no cash flow,

the nonconstant nature of the weighted average cost of capital discount rate

through time, the estimation of an asset's economic life, forecast errors in

creating the future cash flows, and insufficient tests for plausibility of the

final results.

Discount factor - the same for different type of assets.

For instance, the NPV is calculated as the present value of future net free cash

flows (benefits) less the present value of implementation costs (investment

costs). However, in many instances, analysts tend to discount both benefits

and investment costs at a single identical market risk-adjusted discount rate,

usually the WACC. This, of course, is flawed.

The benefits should be discounted at a market risk-adjusted discount

rate like the WACC, but the investment cost should be discounted at a

reinvestment rate similar to the risk-free rate. Cash flows that have market

risks should be discounted at the market risk-adjusted rate, while cash flows

that have private risks should be discounted at the risk-free rate. This is

because the market will only compensate the firm for taking on the market

risks but not private risks. It is usually assumed that the benefits are subject

to market risks (because benefit free cash flows depend on market demand,

market prices, and other exogenous market factors), while investment costs

depend on internal private risks (such as the firm's ability to complete building

a project in a timely fashion or the costs and inefficiencies incurred

beyond what is projected). On occasion, these implementation costs may also be discounted at a rate slightly higher than a risk-free rate, such as a

money-market rate or at the opportunity cost of being able to invest the sum

in another project yielding a particular interest rate. Suffice it to say that

benefits and investment costs should be discounted at different rates if they

are subject to different risks.

Otherwise, discounting the costs at a much

higher market risk-adjusted rate will reduce the costs significantly, making

the project look as though it were more valuable than it actually is.

At the same time Discounted Cash Flow method is not so popular due to its disadvantages.

Advantages Discounted Cash Flow Advantages

_ Clear, consistent decision criteria for all projects.

_ Same results regardless of risk preferences of investors.

_ Quantitative, decent level of precision, and economically rational.

_ Not as vulnerable to accounting conventions (depreciation, inventory

valuation, etc.).

_ Factors in the time value of money and risk structures.

_ Relatively simple, widely taught, widely accepted.

_ Simple to explain to management: "If benefits outweigh the costs, do it!"

"Forecast the likely distribution" - prassan p.38

Corp finance:

The goal of a corporation is to max value. A shareholder value maximizing investment rule is based on cash flows; taking into account time value of money; taking into account different risks. The npv rules meet all the requirements and directly measures the value for shareholders created by a project.

4.9 Advantages of NPV

The advantages of NPV are as follows.

A´â‚¬AA  It is directly linked to the assumed objective of maximising shareholder wealth as it measures, in

absolute (£) terms, the effect of taking on the project now, ie year 0

A´â‚¬AA  It considers the time value of money, ie the further away the cash flow the less it is worth in present

terms

A´â‚¬AA  It considers all relevant cash flows, so that it is unaffected by the accounting policies which cloud

profit-based investment appraisal techniques such as ARR

A´â‚¬AA  Risk can be incorporated into decision making by adjusting the company's discount rate

A´â‚¬AA  It provides clear, unambiguous decisions, ie if the NPV is positive, accept; if it is negative, reject.

4.11 Advantages of DCF methods of appraisal

Taking account of the time value of money (by discounting) is one of the principal advantages of the DCF

appraisal method. Other advantages include the following.

A´â‚¬AA  The method uses all cash flows relating to the project

A´â‚¬AA  It allows for the timing of the cash flows

A´â‚¬AA  There are universally accepted methods of calculating the NPV and IRR

Assumptions. DCF Assumptions

Real Option Valuation

Strategic value when there is a possibility to make contingent decisions.

Summary

Traditional analyses like the discounted cash flow are fraught with problems.

They underestimate the flexibility value of a project and assume that

all outcomes are static and all decisions made are irrevocable. In reality,

business decisions are made in a highly fluid environment where uncertainties

abound and management is always vigilant in making changes in

decisions when the circumstances require a change. To value such decisions

in a deterministic view may potentially grossly underestimate the true intrinsic

value of a project. New sets of rules and methodology are required in

light of these new managerial flexibilities. It should be emphasized that real

options analysis builds upon traditional discounted cash flow analysis, providing

value-added insights to decision-making.

Comparison

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