Budgeting

Advantages and Disadvantages of Discounted Cash Flow Methods

Discounted Cashflows Methods: Another method of computing expected rates of return is the present value method. The method is popularly known as Discounted Cash flow Method also. This method involves calculating the present value of the cash benefits discounted at a rate equal to the firm’s cost of capital. In other words, the present value of an investment is the maximum amount a firm could pay for the opportunity of making the investment without being financially worse off.

The financial executive compares the present values with the cost of the proposal. If the present value is greater than the net investment, the proposal should be accepted. Conversely, if the present value is smaller than the net investment, the return is less than the cost of financing. Making the investment in this case will cause a financial loss to the firm. There are four methods to judge the profitability of different proposals on the basis of this technique.

(i) Net Present Value Method:

This method is also known as Excess Present Value or Net Gain Method. To implement this approach, we simply find the present value of the expected net cash inflows of an investment, discounted at the cost of capital and subtract from it the initial cost outlay of the project. If the net present value is positive, the project should be accepted: if negative, it should be rejected.

NPV = Total Present value of cash inflows – net investment.

If the two projects are mutually exclusives the one with higher net present value should be chosen. The following example will illustrate the process

Assumed that the cost of capital after taxes of a Canadian firm is 6% Assume further, that the net cash-inflow (after taxes) on a USD 5,000 investment are forecasted as being USD 2,800 per annum for 2 years. The present value of this stream of net cash-inflow discounted at 6% comes to USD 5,272 (1.813 x USD 2800). Therefore, The present value of the cash inflow =   USD 5,272

Less: present value of net investment = USD 5,000

Net Present Value                                     USD 272.

(ii) Internal Rate of Return Method:

This method is popularly known as time adjusted rate of return method/discounted rate of return method also. The internal rate or return is defined as the interest rate that equate the present value of expected future receipts to the cost of the investment outlay. This internal rate return found by trial and error. First, we compute the present value of the cash-flows from an investment, using an arbitrarily elected interest rate. Then we compare the present value so obtained with the investment cost. If the present value is higher than the cost figure, we try a higher rate of interest and go through the procedure again.

Conversely, if the present value is lower than the cost, lower the interest rate and repeat the process. The interest rate that brings about this equality is defined as the internal rate of return. This rate of return is compared to the cost of capital and the project having higher difference, if they are mutually exclusive, is adopted and other one is rejected. As the determination of internal rate of return involves a number of attempts to make the present value of earnings equal to the investment, this approach is also called the Trial and Error Method.

(iii) Benefit cost Ratio or Profitability Index Method:

One major disadvantage of the present value method is that it is not easy to rank projects on the basis of net present value particularly when the cost of projects differ significantly. To compare such projects the present value profitability index is prepared. The index established relationship between cash-inflows and the amount of investment as per formulae :

P.V. Index = NPV / Investment x 100 or  GPV / Investment x 100

For example, the profitability index of the USD 5,000 investment discussed in Net Present Value Method in previous article would be : 272/5000 x 100=105.44

The higher profitability index, the more desirable the investment. Thus, this index provides a ready comparability of investment having various magnitudes. By computing profitability indices for various projects, the financial manager can rank them in order of their respective rates of profitability.

(iv) Terminal Value Method:

This approach separates the timing of the cash-inflows and outflows more distinctly. Behind this approach is the assumption that each cash-inflow is reinvested in another assets at the certain rate of return from the moment it is received until the termination of the project. Then the present value of the total compounded sum is calculated and it is compared with the initial cash-outflow. The decision rule is that i f t he present value of the sum total of the compounded reinvested cash-inflows is equate the present value of cash- outflows, the proposed project is accepted otherwise not. The firm would be different if both the values are equator.

This method has a number Of advantages. It incorporates the advantage of re-investment of cash inflows by compounding and then discounting it.

Further, it is best suited to cash budgeting requirements. The major practical problem of this method lies in projecting the future rates of interest at which the intermediate cash inflows received will be re-invested.

Advantages of Discounted Cash Flow Methods

(1) This method takes into account the entire economic life of an investment and income therefrom. It gives the rake of return offered by a new project.

(2) It gives due weight to time factor of financing. In the words of Charles T. Horngren “Because the discounted cash-flow method explicitly and routinely weights the time value of money, it is the best method to use for long-range decisions.”

(3) It permits direct comparison of the projected returns on investments with the cost of borrowing money which is not possible in other methods.

(4) It makes allowance for differences in the time at which investments generate their income.

(5) This approach by recognizing the time factor makes sufficient provision for uncertainty and risk. It offers a good measure of relative profitability of capital expenditure by reducing the earnings to the present values.

Disadvantages of Discounted Cash Flow Methods

This method is criticized on the following grounds

(1) It involves a good amount of calculations. Hence it is difficult and complicated one. But this criticism has no force.

(2) It is very difficult to forecast the economic life of any investment exactly.

(3) The selection of cash-inflow is based on sales forecasts which is in itself an indeterminable element.

(4) The selection of an appropriate rate of interest is also difficult.

But despite these defects, this approach afford on opportunity for making valid comparisons between several long-term competing capital projects. J. Batty has very rightly remarked. Allowing for these apparent defects there is still a very strong case of using the present values concept. Values and costs should be shown at their true worth, only then when the management accountant say that he is truly representing facts which represents economic realities and not simply a list unrelated figures. The process of discounting brings them all into present day terms allowing valid comparisons to be made.

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