Table of Contents
Discount Cash flow techniques for valuation
- This method works on the below statement by which ordinary people understand easily;’ Any amount of money is worth more at present period compare to get the Same amount In future. ‘
- The above statement is the basis of the economy, saying, “Time is Money. “
- Cause of this Aspect future receivable income(income flow) is considered less worthy today or less valuable. In other words, on present-day future income has to be discounted to balance its purchasing power.
- The process of determining the actual present value of the future receivable income flow or stream of income is known as Discounting.
What Is the Discount Factor?
- The discount factor provides an easy way to calculate the net present value (NPV). This is a weighing term primarily used in economics and mathematics where multiplying future income flows or losses to determine the essential factor by which the value is multiplied to get the present value.
- Primarily applicable in services, goods, or investments. Moreover, it is also used in corporate budgeting to determine whether a project is acceptable for future profitability.
How to Calculate Discounting Factor?
Discount Factor = 1 / (1 * (1 + r)^n
Where, r=discount rate
n=number of years
The following table shows the value of D.F. at a discounting rate of r=10%
- This process finds the discounted value at the present rate of interest today. For example, 100$ is receivable after one year. Its current value is 93.45$ at the 7% Rate of Interest in the market.
- These are primarily acceptable two methods evolved by chartered accountants. Both are known as Discounted Cash flow Techniques (DCF techniques). Both methods are based on Income Generating capabilities (Income Approach).
- Both methods focus on the estimated Income and Expenses forecasted by accountants.
- It works on data of periodic Cash inflow and Cash outflows.
DISCOUNTED CASH FLOW TECHNIQUES;
- NET PRESENT VALUE METHOD (NPV METHOD).
- INTERNAL RATE OF RETURN METHOD ( IRR METHOD).
What is NPV Method?
- In the case of the NPV method, investors know at which rate of return they are investing their money. Moreover, the rate is also fixed by investors as per their expectations. From this info, investors get precise knowledge about the sale price and the fair purchase price of the project.
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Meaning of NPV
- NPV is the difference between the present value of cash inflow and the present value of cash outflows.NPV is used for capital budgeting to analyze the profitability of an investment or project.
- It also revealed profit and loss from that project on a given rate of return, which assists investors in making decisions regarding investments options.
Advantages of NPV
- NPV method is a measure of the contribution.
- It helps to increase the wealth of shareholders as it gives you money.
- This helps to uplift the value of the firm.
- It considers all cash inflows, time value of money.
- This method provides accurate data regarding the forecast of income.
Characteristics of NPV
- Higher-income amounts increase the net present value.
- In the case of profit, the net present value is higher.
- In case of changes in discount rates, may change the value of NPV.
- Calculation of NPV
- The net present value should be calculated by subtracting the present value of cash outflow or expense from the present value of cash inflows.
- Following formula used for calculating NPV:
Where,
CF=C1,C2,C3….are cash inflows of various years
R=desire rate of return
C0=Initial investment
i=1,2,3.. n=1,2,3..
- NPV is mostly preferred due to the following reasons.
- Time value
- The measure of actual profitability
- Value addition/wealth addition
- Shareholders values
What is the IRR method?
- IRR on an investment or project is the annualized effective compounded return rate or rate of return that makes the NPV of all cash flow from a particular investment equal to zero.
- In the case of the IRR method, we have an expected sale or purchase price, so the price is fixed by investors; based on the fixed price, the IRR method help to find the average rate of return on investment.
- Both methods help investors to make decisions on profit base acceptance of projects or divert towards other investments options. In the case of comparison of two investment proposals by both these methods, results are pretty different from both approaches.
- In any case of valuation, As valuers, we can adopt any of these methods based on availabilities of market Info in such circumstances if the valuer has adequate market data available with him about inventors fixed rate of return on the commercial investment. Investors easily make their opinions about acceptability or declination of the proposal of investments on the basis of results under the IRR method.
- We have other comparable commercial investments yield rates to make precise decisions.
- In the above example in the excel table, A bike rental firm evaluates whether to start a new route for tourists.
- Investors accept projects with a higher return; in example 1, we get 13% beyond investors’ desire. To get prices decision, NPV is also considered with IRR.
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ADVANTAGES OF IRR METHOD
- This method indicates a rate of return from the project in which invested.
- It is also known as the “economic rate of return.”
- It shows the return on actual money invested.
- Cost of capital calculation exempted this method.
- It offers the firm’s present value, so the comparison of an old to a new deal is easy for the investors.
- It also helps to calculate the break-even point.
- In this method, approx. Risk premium with the alternative of cost of capital.
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WHICH ONE IS PREFERABLE, NPV OR IRR?
- The following point makes clear concepts of both methods;
- IRR is expressed in terms of percentages, while NPV is calculated in terms of amount.
- IRR method has its limitations, and this method is not helpful in case of a change in the cash inflow pattern.
- NPV also shows the additional wealth gained from projects.
- IRR method is not suitable when projects have multiple positive and negative cash flows.
- NPV is flexible compared to IRR.
- IRR is not showing any positive or negative changes in the wealth of investors.
- The following calculation shows the annual returns from both projects to compare the return and decide investments to the investors.
