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PTTE 434. Economic Analysis of Alternatives Lecture 9. Part 1. Discounting and Cashflow Discounting. The operating premise.
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PTTE 434 Economic Analysis of Alternatives Lecture 9
Part 1 Discounting and Cashflow Discounting
The operating premise .. • The financial value of something today is typicallyregarded as the future payment stream, however calculated, discounted by some acceptable rate of discount, to a present value. • For example, the value of a bond is equal to the valueof all future cash payments (interest and principal redemption) discounted to the future the yield on equivalent bonds. • This discount rate is typically some “opportunity cost”yield. • The slides that follow explain the concept of discounting.
Some Definitions • Present Value: The amount today that a sum of money in the future is worth, given a specified rate of return. • Future Value: The value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today. • Cash Flow: The amount of cash a company generates and uses during a period, calculated by adding noncash charges (such as depreciation) to the net income after taxes. Cash Flow can be used as an indication of a company's financial strength. It is also sometimes referred to as the "money value" of trades in a stock during a trading day.
Some Definitions (Cont’d) • Discounted Cash Flow: A method used to estimate the attractiveness of an investment opportunity. • Cash Flow After Taxes: A company's cash flow after taxes is derived by taking the net income and removing charges for taxes and depreciation. • Life Cycle Cost: The present value sum of all cash flows generated by an investment over the lifetime of that investment (usually after tax). (Note: Government agencies don’t pay taxes, therefore, only the before tax cash flow applies.)
Some Definitions (Cont’d) • Earnings Before Interest and Tax - EBIT: An indicator of a company's financial performance calculated as revenue minus expenses excluding tax and interest. Also referred to as operating earnings. • Earnings Before Interest After Taxes – EBIAT: An indicator of a company's financial performance calculated as: Revenue - COGS - Expenses (including taxes and excluding interest)
What is the formula for calculating the future value X of the present value X invested at f p interest rate r (compounded, annual) for n years?? n X (1 + r ) = X p f The Compounding Formula – Calculates “Future Value”
$10 invested for 10 years at 8% compounded annually will be worth: 10 10 (1.08) = 21.59 An example ...
What is the present value X of some p guaranteed future value X , assuming the f opportunity to invest money today at some compounded interest rate r ?? X f X = p n (1 + r) Present Value Formula
What is the true present value of winning $10 million in the California lottery (paid in 20 equal and annual payments) assuming an interest rate of 8%?? 19 500k S = ??? Value = i (1.08) i=0 The California Lottery
What is the present value of a promise to pay two payments of $ 100 each at a date 5 years in the future and again 10 years in the future, if money today can be expected to earn 12 % between now and then? A question ...
$100 = $56.74 Value5 = 5 X (1.12) f X = p n (1 + r) $100 = $32.20 Value10 = 10 (1.12) Present Value Application Use the present value formula twice and sum the results: = $88.94 +
Some basics Discounting
(1+. 08) Some basics (cont) Value of a perpetuity cashflow Constant cashflow: CF 100 = = = PV $92.59 (1+r) Cashflow growing at rate g: + CF ( 1 g ) 100 ( 1 . 05 ) = = = PV $101.94 - - 1+ 1 +(r g) (. 08 . 05)
Why cashflow matters • Modern valuation techniques use discounted present value free cashflow • Cashflow prior to debt use represents the true strength of the company • To survive, a company must have sufficient cashflow to meet amortized debt and similar obligations
Why cash flow differs from earnings • Some business activities contribute to earnings or constitute expenses, but corresponding cash payments are delayed payables, receivables, inventory. • Some business activities are expensed, but there never is a related cash payment depreciation, amortization, amortization of goodwill.
Why cashflow differs (cont) • Borrowing and the servicing of debt involve expense and revenue entries that do not correspond to concurrent cash transfers • borrowing immediately adds cash but is not directly expensed • loan payments reduce cash, but only the interest component is expensed
Debt and Buying Assets When using debt to buy fixed assets: • Borrowing increases cash at the time of the loan • Buying the asset decreases cash at the time of the purchase • The cost of the loan is expensed only as each payment is made, and then only interest is expensed as interest expense, principal reduction is not expensed. • The fixed asset is not expensed at time of acquisition, but is depreciated slowly over time.
Components of cashflow • Cashflow from operations • adjustments for accruals and amortization • Cashflow from financing • new debt adds, debt payment substracts • Cashflow for investment (GFA usually) • theoretically seen as basis for future value
Earnings Before Interest and Tax (EBIT) Description • Earnings Before Interest and Tax includes all profits, operating and non-operating, before deducting interest and income taxes. • Earnings Before Interest and Tax (EBIT) is a traditional measurement method that does not include capital costs.
Earnings Before Interest and Tax (EBIT) Description (Cont’d) • An advantage of EBIT is it is easier to calculate and easier to observe at divisional or sub divisional levels of the firm. • Instead of EBIT also the terms Operating Profit and Operating Earnings are widely used.
