Financial evaluation of a project
Discounted Cash Flow Method (DCF)
Free cash flow (FCF) which is generated by the company in future and is available for the investors and the life of the project.
The residual value of project at the end of FCF valuation
The formula to calculate DCF is shown below:
PV = CF1 / (1+k) + CF2 / (1+k)2 + … [TCF / (k - g)] / (1+k)n-1
Even though it is the most widely used technique to evaluate the investment yet even this method have some positives and negatives which are discussed below.
Advantages of DCF
Disadvantages of DCF
Advantages of Payback Method
Disadvantages of Payback Method
Difference between discounted cash flows and non discounted cash flow techniques
From the arguments the major difference between discounted cash flow and non discounted cash flow is the consideration of time value of money. Non discounted cash flow techniques consider that value of money will remain the same over the years, which is not the case in real scenario and therefore beside these techniques being easy to use it’s not preferable as it cannot reveal the true results ever due to non consideration of time value of money. Moreover, payback method requires less time, data and is less complex as no forecasting needs to be conducted like DCF method.
Ways to overcome the disadvantages of Payback Method
Discussed below is an example of discounted payback method:
Determine which project Newco should accept thecost of capital is 8.4% and remaining data is below
Payback period for Machine A = 5 + 147/616 = 5.24
Ways to overcome the disadvantages of discounted cash flow method
The above discussed disadvantages of discounted cash flow method highlight that assumptions taken in to account in this model are the major problem as the chances of error are high in it. To eliminate such error...