Conventional and DCF Method, Inflation and Capital Budgeting
CONVENTIONAL CASH FLOW
Conventional cash flow is a series of inward and outward cash flows over time in which there is only one change in the cash flow direction. A conventional cash flow for a project or investment is typically structured as an initial outlay or outflow, followed by a number of inflows over a period of time. In terms of mathematical notation, this would be shown as -, +, +, +, +, +, denoting an initial outflow at time period 0, and inflows over the next five periods.
Discount cash flow (DCF) Method
Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analyses use future free cash flow projections and discounts them, using a required annual rate, to arrive at present value estimates. A present value estimate is then used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.
Types of DCF Techniques:-
There are mainly two types of DCF techniques viz… Net Present Value [NPV] and Internal Rate of Return [IRR].
(A) Net Present Value Techniques [NPV]:
Net Present Value may be defined as the excess of present value of project cash inflows [stream of benefits] over that of outflows [cash outlays]. The cash flows of a project are discounted at some desired rate of return, which is mostly equivalent to the cost of capital.
(B) Internal Rate of Return [IRR]:-
The Internal Rate of Return may be defined as that rate of interest when used to discount the cash flows of an investment, reduce its NPV to zero. Or it is the
rate of discount, which equates the aggregate discounted benefits with aggregate discounted costs.
IRR is also called as ‘Discounted Cash Flow Method’ or ‘Yield Method’ or ‘Time Adjusted Rate of Return Method’. This method is used when the cost of investment and the annual cash inflows are known but the discount rate [rate of return] is not known and is to be calculated.
INFLATION AND CAPITAL BUDGETING
Inflation and capital budgeting are closely related and at no cost capital budgeting can be completed without taking into account inflation. All of us know, that inflation causes our purchasing power to decline. So, if we buy an asset for USD5000 today, it is probable that the same asset can be bought for USD10,000 after a couple of years. However, it is assumed that the project cost as well as net revenues increase in a proportionate manner with inflation. For this reason, in reality rates of inflation are not taken into account. But this is not true always, inflation does affect capital budgeting. Inflation and capital budgeting are bound to affect cash flows .
Effects of Inflation and Capital Budgeting
Inflation affects discount rates and cash flows. There are two factors on which inflation acts. They are discount rate and cash flow.
- Cash flows:
Let us assume that r refers to the revenues; t refers to the tax rate; c is the cost and d is the depreciation. By arranging the above variables in a formula the following is obtained.
(r-c) (1-t) + d = (r-c) (1-t) + dt
Inflation affects (r-c) (1-t), which is on the right side of the equation. But Inflation does not impact dt. The reason can be attributed to the fact that historical costs determine depreciation costs. This implies that inflation has a tendency to decrease the value of real rate of return. Studies reveal that Net cash flow is more as compared to real cash flows provided we do not take inflation into account.
(II) Discount rates:
Discount rates refer to the rate of return, which is the required rate or the target rate. The project cost is inflation adjusted. This adjustment is usually done in the premiums. The required rate or the target rate of return for the investors ought to be the same as real inflation return together with the expected inflation rate.
Mathematical representation of discount rate:
Let us assume that RNT is inflation in nominal terms(required). RR is the real rate of inflation , p is the expected rate of inflation.
The equation is:
RNT = RR + p
We already know that inflation adjusts itself in the premiums. Hence, rate of inflation ought to be highlighted in the cash flows also.