Question

1. Based on the cash flows discounting model, what are the economic determinants of value? (10 Points)

Answer 1

ANSWER:-

Discounting model is one of the methods that is used in capital budgeting process. Discounting model is based on the idea that the present value of asset is equal to future value discounted at an appropriate rate to adjust the risk factor associated with it. The economic determinants of value in the discounting model is the projected cash flows and growth rate associated with them and the discount rate. There is an inverse relationship between the discount rate and present value of cash flows. Higher the discount rates lower will be the present value. There is a direct positive relationship between the growth rate assumption in the discounting model and the present value. Higher the growth rate, higher will be the projected cash flows and higher will be the present value of the cash flows. Discounting model can be used by using different types of cash flows associated with them although we would be required to adjust the discount rate accordingly. When we are using the free cash flows to the firm, we need to take the weighted average cost of capital associated with them and when we are using free cash flow to equity then we need to use the cost of equity associated as the discounting factor. The present value is very much sensitive to the discounting rate and growth rates being used.