Discounted Cash Flow (DCF) Analysis

Discounted Cash Flow (DCF) is a cash flow summary adjusted so as to reflect the time value of money. With DCF, money to be received or paid at some time in the future is viewed as having less value, today, than than an equal amount that is received or paid today.

• Present value (PV) is what the future cash flow is worth today. Futue value (FV) is the value, in non discounted currency units that actually flows in or out at the future time. A $100 cash inflow that will arrive two years from now could, for example, have a present value today of about $94, while its future value is still considered $100. The present value is discounted below the future value. 
• The longer the time period before an actual cash flow event occurs, the more the present value of future money is discounted below its future value.
• The total discounted value (present value) for a series of cash flow events across a time period extending into the future is known as the net present value (NPV) of a cash flow stream. 

DCF can be an important factor when evaluating or comparing investments, proposed actions, or purchases. Other things being equal, the action or investment with the larger DCF is the better decision. When discounted cash flow events in a cash flow stream are added together, the result is called the net present value (NPV).

DCF and NPV and related time value of money concepts are more easily understood when explained together and illustrated, along with related concepts such as discount rate,future value (FV), and present value (PV), as shown in the sections below.

Time value of money in finance and business planning:

When business case or investment projections extend more than a year into the future, professionals trained in finance usually want to see cash flows in both discounted terms and non discounted terms. They want to see projections, that is, that consider the time value of money. In modern finance, time-value-of-money concepts play a central role in decision support and planning.

Time value of money analysis begins with the present value concept, the idea that money you have now is worth more, today, than an identical amount you would receive in the future Why? There are at least 3 reasons:

• Opportunity. The money you have now you could (in principle) invest now, and gain return or interest, between now and the future time. Money you will not have until a future time cannot be used now. 
• Risk. Money you have now is not at risk. Money predicted to arrive in the future is less certain.
• Inflation. A sum you have today will very likely buy more than an equal sum you will not have until years in future. Inflation over time reduces the buying power of money.

Present value, future value, and net present value:

What future money is worth today is called its present value (PV), and what it will be worth in the future when it finally arrives is called not surprisingly its future value (FV). The right to receive a payment one year from now for $100 (the future value) might be worth to us today$95 (its present value). Present value is discounted below future value.

When the analysis concerns a series of cash inflows or outflows coming at different future times, the series is called a cash flow stream. Each future cash flow has its own value today (its own present value). The sum of these present values is the net present value for the cash flow stream. 

Consider an investment today of $100, that brings net gains of $100 each year for 6 years. The future values and present values of these cash flow events might look like this:

 

All three sets of bars represent the same investment cash flow stream. The black bars stand for cash flow figures in the currency units when they actually appear in the future (future values). 

The lighter bars are values of those cash flows now, in present value terms. The net values in the legend show that after five years, the net cash flow expected is $500, but the Net present value today is discounted to something less.

The size of the discounting effect depends on two things: the amount of time between now and each future payment (the number of discounting periods)  and an interest rate called the discount rate. The example shows that:

• As the number of discounting periods between now and the cash arrival increases, the present value decreases.
• As the discount rate (interest rate) in the present value calculations increases, the present value decreases. 

Whether you will or will not calculate present values yourself, your ability to use and interpret NPV / DCF figures will benefit from a simple understanding of the way that interest rates and discounting periods work together in discounting. 

DCF and NPV: Mathematically speaking

DCF and NPV calculations are closely related tocalculations for interest growth and compounding, which are already familiar to most people. Remember briefly how these work. The formula at left looks into the future and might ask, for instance: What is the future value (FV) in one year, of $100 invested today (the PV), at an annual interest rate of 5%?

FV₁  = $100 ( 1 + 0.05)¹ = $105

When the FV is more than one period into the future, as most people know, interest compounding takes place. Interest earned in earlier periods begins to earn interest on itself, in addition to interest on the original PV. Compound interest growth is delivered by the exponent in the FV formula, showing the number of periods. What is the future value in five years of $100 invested today at an annual interest rate of 5%?

FV₅  = $100 ( 1 + 0.05)⁵ = $128

The same formula can be rearranged to deliver a present value given a future value and interest rate for input, as shown at left. Now, the formula starts in the future and looks backwards in time, to today, and might ask: What is the value today of a $100 payment arriving in one year, using a discount rate of 5%?

PV₁ = ($100) / (1.0 + 0.05)¹     = $100 / (1.05)     = $95 

You should be able to see why PV will decrease if we either (a) increase the interest rate, or (b) increase the number of periods before the FV arrives. What is the present value of $100 we will receive in 5 years, using a 5% discount rate?

PV₅  = $100 / (1.0 +0.05)⁵      = $100 / (1.276)     = $75.13

When discounting is applied to a series of cash flow events, a cash flow stream, as illustrated in the graph example above, net present value for the stream is the sum of PVs for each FV:

Finally, note two commonly used variations on the examples shown thus far. The examples above and most textbooks show  "year end" discounting, with periods one year in length, and cash inflows and outflows discounted as though all cash flows in the year occur on day 365 of the year. However:

• Some financial analysts prefer to assume that cash flows are distributed more or less evenly throughout the period, and discounting should be applied when the cash actually flows.
• For calculating present values this way, it is mathematically equivalent to calculate as though all cash flow occurs at mid year.  This is so-called "mid period discounting." 
• Year end discounting is more severe (has a greater discount effect) than mid year (mid period) discounting, because the former discounts all cash flow in the period for the full period.
• When actual cash flow is known or estimated for months, quarters, or some other period, discounting may be performed for each of these periods rather than for one year periods. In such cases, the discount rate used for calculation is the annual rate divided by the fraction of a year covered by a period. Quarterly discounting, for example, would use the annual rate divided by 4.

The formulas at left show NPV calculations for mid-year discounting (upper formula) and for discounting with periods other than one year (lower formula).

In any case, the business analyst will want to find out which of the above discount methods is preferred by the organization's financial specialists, and why, and follow their practice (unless there is justification for doing otherwise).

Working examples of these formulas, along with guidance for spreadsheet implementation and good-practice usage are available in the spreadsheet-based toolFinancial Metrics Pro.

Choosing a discount rate for discounted cash flow analysis:

The analyst will also want to find out from the organization's financial specialists which discount rate the organization uses for discounted cash flow analysis. Financial officers who have been with an organization for some time, usually develop good reasons for choosing one rate or another as the most appropriate rate for the organization.

• In private industry, many companies use their own cost of capital (or weighted average cost of capital) as the preferred discount rate.
• Government organizations typically prescribe a discount rate for use in the organization's planning and decision support calculations. In the United States, for instance, the Office of Management and Budget (OMB) publishes a quarterly circular with prescribed discount rates for Federal Government use.
• Financial officers may use a higher discount rate for investments or decisions viewed as risky, and a lower discount rate when expected returns from a proposed action are seen as less risky.  The higher rate is viewed as a hedge against risk, because it puts relatively more emphasis (weight) on near-term returns compared to distant future returns.

Example: Comparing competing investments with NPV.

Consider two competing investments in computer equipment. Each calls for an initial cash outlay of $100, and each returns a total a $200 over the next 5 years making net gain of $100. But the timing of the returns is different, as shown in the table below (Case A and Case B), and therefore the present value of each year’s return is different. The sum of each investment’s present values is called the discounted cash flow (DCF) or net present value (NPV). Using a 10% discount  rate again, we find:

Timing	CASE A		CASE B
	Net Cash Flow	Present Value	Net Cash Flow	Present Value
Now	– $100.00	– $100.00	– $100.00	– $100.00
Year 1	$60.00	$54.54	$20.00	$18.18
Year 2	$60.00	$49.59	$20.00	$16.52
Year 3	$40.00	$30.05	$40.00	$30.05
Year 4	$20.00	$13.70	$60.00	$41.10
Year 5	$20.00	$12.42	$60.00	$37.27
Total	Net CFA =  $100.00	NPVA = $60.30	Net CFB = $100.00	NPVB = $43.12

Comparing the two investments, the larger early  returns in Case A lead to a better net present value (NPV) than the later large returns in Case B. Note especially the Total line for each present value column in the table. This total is the net present value (NPV) of each "cash flow stream." When choosing alternative investments or actions, other things being equal, the one with the higher NPV is the better investment.

When to use DCF and NPV in the business case:

In brief, an NPV / DCF view of the cash flow stream should probably appear with a business case summary when:

• The business case deals with an "investment" scenario of any kind, in which different uses for money are being compared.
• The business case covers long periods of time (two or more years).
• Inflows and outflows change differently over time (e.g., the largest inflows come at a different time from the largest outflows).
• Two or more alternative cases are being compared and they differ with respect to cash flow timing within the analysis period.

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Depriciation Analysis

Why depreciation is a Non Cash Expense?, Why Reserve Maintained for Depreciation ? , Why Depreciation expense needs to be added back to Net Income in Cash Flow.

Definition of Depreciation:

Financial Reporting Standard 15 (covering the accounting for tangible fixed assets) defines depreciation as follows:

"The wearing out, using up, or other reduction in the useful economic life of a tangible fixed asset whether arising from use, effluxion of time or obsolescence through either changes in technology or demand for goods and services produced by the asset.'

A portion of the benefits of the fixed asset will be used up or consumed in each accounting period of its life in order to generate revenue. To calculate profit for a period, it is necessary to match expenses with the revenues they help earn.

In determining the expenses for a period, it is therefore important to include an amount to represent the consumption of fixed assets during that period (that is, depreciation).

In essence, depreciation involves allocating the cost of the fixed asset (less any residual value) over its useful life. To calculate the depreciation charge for an accounting period, the following factors are relevant:

- the cost of the fixed asset;

- the (estimated) useful life of the asset;

- the (estimated) residual value of the asset.

What is the relevant cost of a fixed asset?

The cost of a fixed asset includes all amounts incurred to acquire the asset and any amounts that can be directly attributable to bringing the asset into working condition.

Directly attributable costs may include:

- Delivery costs

- Costs associated with acquiring the asset such as stamp duty and import duties

- Costs of preparing the site for installation of the asset

- Professional fees, such as legal fees and architects' fees

Note that general overhead costs or administration costs would not be included as part of the total costs of a fixed asset (e.g. the costs of the factory building in which the asset is kept, or the cost of the maintenance team who keep the asset in good working condition)

The cost of subsequent expenditure on a fixed asset will be added to the cost of the asset provided that this expenditure enhances the benefits of the fixed asset or restores any benefits consumed.

This means that major improvements or a major overhaul may be capitalised and included as part of the cost of the asset in the accounts.

However, the costs of repairs or overhauls that are carried out simply to maintain existing performance will be treated as expenses of the accounting period in which the work is done, and charged in full as an expense in that period.

What is the Useful Life of a fixed asset?

An asset may be seen as having a physical life and an economic life.

Most fixed assets suffer physical deterioration through usage and the passage of time. Although care and maintenance may succeed in extending the physical life of an asset, typically it will, eventually, reach a condition where the benefits have been exhausted.

However, a business may not wish to keep an asset until the end of its physical life. There may be a point when it becomes uneconomic to continue to use the asset even though there is still some physical life left.

The economic life of the asset will be determined by such factors as technological progress and changes in demand. For purposes of calculating depreciation, it is the estimated economic life rather than the potential physical life of the fixed asset that is used.

What about the Residual Value of a fixed asset?

At the end of the useful life of a fixed asset the business will dispose of it and any amounts received from the disposal will represent its residual value. This, again, may be difficult to estimate in practice. However, an estimate has to be made. If it is unlikely to be a significant amount, a residual value of zero will be assumed.

The cost of a fixed asset less its estimated residual value represents the total amount to be depreciated over its estimated useful life.

Depreciation of fixed assets :Introduction

In our introduction to accounting for fixed assets, we described how businesses need to account for the consumption of fixed assets over time in a way that reflects their reducing value. The term given to this consumption is depreciation. This revision note explains the various methods available to calculate depreciation and highlights how subjective this calculation can be. Other revision notes provide worked example of each depreciation method.

Depreciation Methods :

The total amount to be depreciated over the life of a fixed asset is determined by the following calculation:

Cost of the fixed asset less residual value

The period over which to depreciate a fixed asset is known as the "useful economic life" of the asset.

So how much of this depreciable amount is charged against profits in each accounting period?

A depreciation method is required to allocate, in a systematic way, the total amount to be depreciated between each accounting period of the asset's useful economic life.

There are various methods of depreciation available. However, most businesses appear to adopt one of the two methods described below.

Method 1 - Straight-line depreciation:

The straight-line method of depreciation is widely used and simple to calculate. It is based on the principle that each accounting period of the asset's life should bear an equal amount of depreciation.

As a result, the depreciation charge for the asset can be calculated using the following formula:

Dpn = (C- R)/ N

where:

Dpn = Annual straight-line depreciation charge

C = Cost of the asset

R = Residual value of the asset

N = Useful economic life of the asset (years)

Whilst it is simple and popular, Is the straight line depreciation method the most appropriate way of calculating depreciation?

The answer lies in understanding that depreciation is a process of allocation, not valuation.

The pattern of annual depreciation charges for a fixed asset should attempt to match the pattern of benefits derived from that asset. Therefore, where the benefits from an asset are likely to be reasonably constant over its life the straight-line method of depreciation would be appropriate as it results in a constant annual depreciation charge.

In practice it may be difficult to assess the pattern of benefits relating to an asset. In such cases the straight-line method may often be chosen simply because it is easy to understand and calculate.

Method 2 - Reducing balance method:

The reducing balance method of depreciation provides a high annual depreciation charge in the early years of an asset's life but the annual depreciation charge reduces progressively as the asset ages.

To achieve this pattern of depreciation, a fixed annual depreciation percentage is applied to the written-down value of the asset. Thus, depreciation is calculated as a percentage of the reducing balance.

For certain fixed assets, the benefits derived may be high in the early years, but may decline as the asset ages. For such assets, the reducing-balance method of depreciation would be appropriate insofar as it matches the depreciation expense with the pattern of benefits.

Once a particular method of depreciation has been chosen for a fixed asset, the method should be applied consistently over its life. It is only permissible to switch from one method to another if the new method provides a fairer presentation of the financial results and financial position.

Total depreciation charged

It should be noted that, whichever method of depreciation is selected, the total depreciation to be charged over the useful life of a fixed asset will be the same.

It is simply the allocation of the total depreciation charge between accounting periods that is affected by the choice of method.

Need for Provision of Depreciation:
The need for provision for depreciation arises for the following reasons:

(1) Ascertainment of true profit or loss-Depreciation is a loss. So unless it is considered like all other expenses and losses, true profit/loss cannot be ascertained. In other words, depreciation must be considered in order to find out true profit/loss of a business.

(2) Ascertainment of true cost of production-Goods are produced with the help of plant and machinery which incurs depreciation in the process of production. This depreciation must be considered as a part of the cost of production of goods. Otherwise, the cost of production would be shown less than the true cost. Sale price is normally fixed on the basis of cost of production. So, if the cost of production is shown less by ignoring depreciation, the sale price will also be fixed at a low level resulting in loss to the business;

(3) True Valuation of Assets-Value of assets gradually decreases on account of depreciation. If depreciation is not taken into account, the value of asset will be shown in the books at a figure higher than its true value and hence the true financial position of the business will not be disclosed through Balance Sheet.

(4) Replacement of Assets-After some time an asset will be completely exhausted on account of use. A new asset then be purchased requiring large sum of money. If the whole amount of profit is withdrawn from business each year without considering the loss on account of depreciation, necessary sum may not be available for. buying the new assets. In such a case the required money is to be collected by introducing fresh capital or by obtaining loan by selling some other assets. This is contrary &0sound commercial policy.

(5) Keeping Capital' Intact-Capital invested in buying an asset, gradually diminishes on account of depreciation. If loss on account of depreciation is not considered in determining profit/ loss at the year end, profit will be shown more. If the excess profit is withdrawn, the working capital will gradually reduce, the business will become weak and its profit earning capacity will also fall.

 (6) Legal Restriction-According to Sec. 205 of the Companies Act, 1956 dividend cannot be declared without charging depreciation on fixed assets. Thus in "Case of joint stock companies charging of depreciation is compulsory.

Sources :  ezinearticles.com , tutor2u.net,accountingcoach.com

Why Depreciation Expense needs to be added back to Net Income in Cash Flow ?

Depreciation Expense:

Depreciation moves the cost of an asset to Depreciation Expense during the asset's useful life. The accounts involved in recording depreciation are Depreciation Expense and Accumulated Depreciation. As you can see, cash is not involved. In other words, depreciation reduces net income on the income statement, but it does not reduce the Cash account on the balance sheet.

Because we begin preparing the statement of cash flows using the net income figure taken from the income statement, we need to adjust the net income figure so that it is not reduced by Depreciation Expense. To do this, we add back the amount of the Depreciation Expense.

Depletion Expense and Amortization Expense are accounts similar to Depreciation Expense, as all three involve allocating the cost of a long-term asset to an expense over the useful life of the asset. There is no cash involved.

In the operating activities section of the cash flow statement, add back expenses that did not require the use of cash. Examples are depreciation, depletion, and amortization expense.

Let's illustrate how a depreciation expense is handled by continuing with the Good Deal Co.

June Transactions and Financial Statements:

The only transaction recorded by Good Deal during June was the depreciation on the office equipment. Recall that on May 31 Good Deal purchased the office equipment (a new computer and printer) for $1,100 and it was put into service on the same day. Let's assume that a depreciation expense of $20 per month is recorded by Good Deal. As a result, Good Deal's financial statements at June 30 will be as follows:

Good Deal Co. Income Statement For the Month Ended June 30, 2012 Revenues $  0  Expenses Depreciation Expense   20  Net Income $(20)

Good Deal Co. Income Statement For the Six Months Ended June 30, 2012 Revenues $800 Expenses Cost of Goods Sold 500 Depreciation Expense     20 Total Expense   520 Net Income $280

Good Deal Co. Balance Sheet June 30, 2012 Assets Liabilities & Owner's Equity Cash $   850  Liabilities Accounts Receivable 0  Accounts Payable $       0 Inventory 200  Owner's Equity Supplies 150  Matt Jones, Capital (excl. net inc.) 2,000 Office Equipment 1,100  Matt Jones, Curr Yr. Net Income      280 Less: Accum. Depreciation      (20) Total Matt Jones, Capital   2,280 Total Assets $2,280  Total Liabilities & Owner's Equity $2,280

A balance sheet comparing June 30 to May 31 and the resulting differences or changes is shown below:

Good Deal Co. Balance Sheets June 30 and May 31, 2012 Assets 6-30-12  5-31-12 Change  Cash $   850  $   850 $   0  Accounts Receivable 0  0 0  Inventory 200  200 0  Supplies 150  150 0  Office Equipment   1,100  1,100 0  Less: Accumulated Depreciation      (20)          0   (20) Total Assets $2,280  $2,300 $(20) Liabilities & Owner's Equity Liabilities Accounts Payable $       0  $       0 $   0  Owner's Equity Matt Jones, Capital (excl. net inc.) 2,000  2,000 0  Matt Jones, Curr Yr. Net Income      280       300   (20) Total Matt Jones, Capital   2,280    2,300   (20) Total Liabilities & Owner's Equity $2,280  $2,300 $(20) (If you are wondering why June 30 is shown before May 31, it is because accountants usually place the most current amounts closest to the account names. This is a courtesy to the reader in that these are assumed to be the more important amounts and will be easier to read if placed closest to the words.)

Good Deal Co. Statement of Cash Flows For the Month Ended June 30, 2012 Operating Activities Net Income $ (20) Add: Depreciation Expense     20  Cash Provided (Used) in Operating Activities 0  Investing Activities 0  Financing Activities       0  Net Increase in Cash     0  Cash at the beginning of the month   850  Cash at the end of the month $850

The cash flow statement for the month of June illustrates why depreciation expense needs to be added back to net income. Good Deal did not spend any cash in June, however, the entry in the Depreciation Expense account resulted in a net loss on the income statement. To convert the bottom line of the income statement (a loss of $20) to the amount of cash provided or used in operating activities ($0) we need to add back or remove the depreciation expense amount.

Good Deal Co. Balance Sheets June 30, 2012 and December 31, 2011 Assets 6-30-12  12-31-11 Change  Cash $   850  $   0 $    850  Accounts Receivable 0  0 0  Inventory 200  0 200  Supplies 150  0 150  Office Equipment   1,100  0 1,100  Less: Accumulated Depreciation      (20)      0      (20) Total Assets $2,280  $   0 $2,280  Liabilities & Owner's Equity Liabilities Accounts Payable $       0  $   0 $       0  Owner's Equity Matt Jones, Capital (excl. net inc.) 2,000  0 2,000  Matt Jones, Curr Yr. Net Income      280       0      280  Total Matt Jones, Capital   2,280       0   2,280  Total Liabilities & Owner's Equity $2,280  $   0 $2,280

Good Deal Co. Statement of Cash Flows For the Six Months Ended June 30, 2012 Operating Activities Net Income $   280  Add back: Depreciation Expense 20  Increase in Inventory (200) Increase in Supplies     (150) Cash Provided (Used) in Operating Activities (50) Investing Activities Increase in Office Equipment (1,100) Financing Activities Investment by Owner   2,000  Net Increase in Cash    850  Cash at the beginning of the year         0  Cash at June 30, 2012 $   850

Let's review the cash flow statement for the six months ended June 30:

• The operating activities section starts with the net income of $280 for the six-month period. Depreciation expense is added back to net income because it was a noncash transaction (net income was reduced, but there was no cash spent on depreciation). The increase in the Inventory account is not good for cash, as shown by the negative $200. Similarly, the increase in Supplies is not good for cash and it is reported as a negative $150. Combining the amounts, the net change in cash that is explained by operating activities is a negative $50.
• The increase in long-term assets caused a cash outflow of $1,100 which is reported in the investing activities section.
• There were no changes in long-term liabilities. There was a change in owner's equity since December 31, and as a result the financing activities section reports the owner's $2,000 investment into the Good Deal Co.
• Combining the operating, investing, and financing activities, the statement of cash flows reports an increase in cash of $850. This agrees with the change in the Cash account as shown on the balance sheets from December 31, 2011 and June 30, 2012.

Sources :  ezinearticles.com , tutor2u.net,accountingcoach.com