Question

Describe three different examples of analysis where you might use discounted cash flows.

Answer 1

Three examples of analysis where we use discounted cash flows are:

1. Capital budgeting: Using the Net Present Value method we decide to accept or reject a project. In this method we find out the present value of the cash flow expected in future by using the concept of discounted cash flows. Suppose Company A expects cash flow of $ 20000 in year 1, $25000 in year 2, $30000 in year 3 then we find out the present value of the cash flows by multiplying the amount by a suitable discounting factor for the number of years in which the cash flow is expected and the rate of interest. For example $30000 in 3 years will have a present value of $22539.44 at 10% interest. We add the present value of all the cash flows and if it is greater than the investment then we accept the project.

2.Valuation of Bonds: Bonds are valued by the concept of discounted cash flow analysis:

Bond price= Coupon/(1+i)¹+Coupon/(1+i)²+…+Value at maturity/(1+i)ⁿ

Where Coupon is the interest payment

i is the interest rate

Value at maturity is the par value of the bond.

3. Valuation of Stock: According to the Dividend Discount model the value of a share is the sum of all the future dividend payment discounted back to their present value. Thus the value of a share is the sum of the net present value of all the dividends paid by the company.

Price = Dividend₁/ (1+k) ¹+ Dividend ₂/ (1+k) ²+…+ Dividend _n / (1+k) ⁿ

    Where k is the cost of equity of the company

    n is the number of years