REVISITING DISCOUNTED CASH FLOWS MODEL AS A CAPITAL BUDGETING DECISION TOOL

Year 2020, , 60 - 63, 31.12.2020

Suat Teker

https://doi.org/10.17261/Pressacademia.2020.1349

Abstract

Purpose- In this study, the classical discounted cash flows (DCDF) model is revisited and the input factors of the model are analysed in details.
Methodology- A model analysis approach is used in this research. The fundamental assumptions and the input factors (cash flows, time period, risk, discount rate, etc.) of DCF model are questioned.
Findings- NPV and IRR are two methods using discounted cash flows and oftenly applied for capital budgeting decisions. The assumptions used in the DCF analysis are very strong and not fitting well in the reality of practical life. Economic life of the project may be much longer or shorter than projected in the analysis. The computation of discount rate bases on subjective interpretations (weights of capital components, cost of debt, opportunity cost of equity). Estimation of cash flows is the most critical input of the analysis but generally the least weighted factor (CF or FCF, inclusion of only relevant cash flows, depreciation and interest expenses, installments, credit sales and purchases, etc.). Risk adjustment can be made either on the discount rate or expected cash flows. Moreover, the analysis of international capital investments makes the issue more complicated. Also, the inclusion of real options adds an economic value to the analysis.
Conclusion- DCF is not straight forward a capital budgeting model anyone can easily use. The application of DCF requires expertise and a picky view on details. Nevertheless, the acceptance of capital investments utilizing DCF method can not be independent of overall company strategic goals.

Keywords

Discounted cash flows, discount rate, capital budgeting decisions

References

• Alessii, Giuseppe, (2006). Payback Period and Internal Rate of Return in Real Option Analysis.Engineering Economist 51:3, 237–257.
• Arnold, Tom, and Timothy Crack. (2004a). Using the WACC to Value Real Options. Financial Analysts Journal 60:6, 78–82.
• Arnold, Tom, and Timothy Crack. (2004b). Real Option Valuation Using NPV. Available at http://ssrn.com/abstract=644081.
• Baker, H. Kent, and Gary E. Powell. (2005). Understanding Financial Management: A Practical Guide. Malden, MA: Blackwell Publishing.
• Chen, Shimin. (2008). DCF Techniques and Nonfinancial Measures in Capital Budgeting: A Contingency Approach Analysis. Behavioral Research in Accounting 20:1, 13–29.
• Courtois, Yves, Gene Lai, and Pamela Peterson. (2008). Cost of Capital.” In Michelle R. Clayman, Martin S. Fridson, and George Troughton, eds. Corporate Finance: A Practical Approach, 127–169. Hoboken, NJ: John Wiley & Sons.
• Fernandez, Pablo. (2007). Company Valuation Methods: The Most Common Errors in Valuations Available at http://ssrn.com/abstract=274973.
• Grinyer, John R., C. Donald Sinclair, and Daing Nasir Ibrahim. (1999). Management Objectivesin Capital Budgeting. Financial Practice and Education 9:2, 12–22.
• IOMA. (2003). Analyzing New Products: Choice of Hurdle Rate & Cash-Flow Assumptions Key to Decision Making. IOMA’s Report on Financial Analysis, Planning & Reporting 3:10, 4–7.
• Jensen, Michael C. (2001). Value Maximization, Stakeholder Theory, and the Corporate Objective Function. Journal of Applied Corporate Finance 14:3, 8–21.
• Myers, Stewart C. (1977). Determinants of Corporate Borrowing. Journal of Financial Economics. 5:2, 147–175.
• Petty, J. William, and John T. Rose. (2009). Free Cash Flow, the Cash Flow Identity, and the Accounting Statement of Cash Flows. Journal of Financial Education 35:Fall, 41–55.
• Pratt, Shannon, and Roger J. Grabowski. (2008). Cost of Capital: Applications and Examples, 3rd ed. Hoboken, NJ: JohnWiley & Sons