Share
Explore BrainMass

# The Discounted Cash Flows Model

Investors will buy shares in a company when they believe they will receive a return on their investment, either in the form of dividends (that is, regular cash distributions of a corporation's profits) or an appreciation in the value of the stock (that is, they can sell the stock for more tomorrow than they would today). There are different ways that investors typically look to value, or price, a stock. The most common methods price a stock equal to the present value of expected future earnings, cash flow or dividends using the discounted cash flow method. Under these methods, financial analysts look carefully at a corporation's financial statements to determine an appropriate model for forecasting these future amounts. These future amounts are typically discounted at a risky rate of return as determined using the Capital Asset Pricing Model (CAPM).

Dividend Discount Model (Gordon Growth Model)
A common discounted cash flow method that finance students use is the Dividend Discount Model (or Gordon Growth Model). This model assumes that a corporation pays out all its earnings as dividends and that dividends grow at a constant rate in perpetuity. These assumptions do produce some problems with the model; however, it gives students a good sense of how the underlying value of a stock relates to real things such as dividends, and can provide information to increase the accuracy of predictions when other models are used in conjunction. In this model, the value of a stock is worth the sum of all of the discounted future dividend payments.

Where P = the price of the stock
D = the value of the first dividend payment
r = the interest rate, expected rate of return or discount rate
g = the growth rate of the dividends (retention ratio x return on retained earnings)

Comparative Methods
Many people have heard of terms such as Price-to-Earnings Ratio (P/E Ratio) and Return on Assets. These numbers give us a good idea of how a company is performing. For example, if a stock is trading at \$1/share and has an Earnings per Share (EPS) of \$0.10, we say it has a P/E Ratio of 10 (1/0.10 = 10). We can then compare it to similar firms, for example, in the same industry, of the same size, and/or with the same capital structure. Now, let's assume these comparative firms are trading at a P/E ratio on average of 5. Given our EPS of \$0.10, we may determine that \$0.50 (\$0.10 x 5 = \$0.50) is a more appropriate price for our stock. Similarly, if these comparative firms are trading at P/E Ratios of more than 10, we may conclude that our stock is under priced, and we would want to buy more of it. In this type of analysis, we can use many different types of information on a stock including EPS, P/E Ratios, Return on Capital Invested (ROIC), Return on Assets (ROA), Price to Sales Ratio (P/S Ratio), Earnings (EBITDA, for example), and Earnings to Equity Value Ratio, among the many.

### Net Present Value Method for Better Plastics

The management of Better Plastics has recently been looking at a proposal to purchase a new plastic-injection-style molding machine. With the new machine, the company would not have to buy small plastic parts to use in production. The estimated useful life of the machine is 15 years, and the purchase price, including all setup c

### OCF NPV Deciding Firms

a firm is deciding on a new project. Use the following information for the project evaluation and analysis the initial costs are 450,000 for fixed assets. The fixed assets will be depreciated straight line to a zero-book value over the 3-year life of the project. The fixed assets have an estimated salvage value of \$30,000 at t

### Business / Finance / Decision Tree

Decision Tree Analysis: Investment Options Marcal Corporation is considering foreign direct investment in Asia. The company estimates that the project would require an initial investment of \$14 million. and generate positive cash flows of \$2 million a year at the end of each of the next 20 years. The project's cost of ca

### Equivalent annual savings

Hi, Please help me with the question below. I am not sure what I am missing, my answer is not coming out right. Question below: Gluon Inc. is considering the purchase of a new high pressure glueball. It can purchase the glueball for \$220,000 and sell its old low-pressure glueball, which is fully depreciated, for \$40,0

### Construction of a pro forma income statement

Construct a pro forma income statement for the first year and second year for the following assumptions: - Units of Sales in Year 1: 110,000 - Price per Unit: \$11 - Variable cost per unit: 25% - Fixed Costs: \$129,000 - Income taxes: 20% - Interest Expense: \$170,000 - In year 2, Price per unit increases to \$13.50, and un

### A Business Statement of Cash Flows— Operating Activities Detail: Concept Connection

Example 3- 1 ( page 80) 2. Timberline Inc. had the following current accounts last year. (\$ 000) Beginning Ending Cash \$ 175 \$ 238 Accounts payable \$ 205 \$ 182 Accounts receivable 1,456 2,207 Accruals 95 83 Inventory 943 786 Current assets \$ 2,574 \$ 3,231 Current liabilities \$ 300 \$ 265 In addition, the co

### Maximize Earnings vs Firm Value

Explain why managers who attempt to maximize earnings might not maximize firm value.

### Value of Company and Discounted Cash Flows

What is the value of a company with the following cash flows? Year1 - \$3 million Year 2 - \$6 million Year 3 - \$2 million Years 4 - 10 - \$2.5 million year 4, growing at 30% annually through year 10 Year 11 - 8% annual growth from year 10 cash flow indefinitely WACC of 11.5% Thank you very much for using BrainMass.com

### Uneven Cash Flows & Purchasing Power vs. Inflation

See attachment. Q5 At an inflation rate of 9 percent, the purchasing power of RM1 would be cut in half in 8.04 years. How long to the nearest year would it take the purchasing power of RM1 to be cut in half if the inflation rate were only 4 percent? Q6 A project with a 3-year life has the following probability distribu

### Financial Management: Net Present Value Analysis

Suppose a company has hired you to estimate the cash flows arising from a proposed capital project by replacing old equipment with a \$0 market value and a book value of \$6000, and you have been handed the relevant data below. The project being considered has a 5-year tax life, and at the end of year 5 the asset will be worthless

### Concepts: BEP and TIE, Annuity vs. Annuity due, Loan Amortization, Present and Future Value

b. Briefly discuss the concept of relevant cash flows when evaluating a new project. 1- Explain the relationship between (i) discount rate and present value, and (ii) compound rate and future value. 2- Why is the future value for an annuity due always higher than that of an ordinary annuity? 3- Although the payment ma

### Short Sell and Margin Account

Q1. JLJ Corporation has the following balance sheet: Assets (2-year average) Debt and Equity (2-year average) Cash and marketables 2,900 Accounts payable 1,459 Inventories 1,746 Accrued liabilities 1,085 Current Assets 4,646 Current Liabilities 2,544 PPE 4,750 Long-term debt 4,953 Other assets 425 Stockholder's equity 2,

### CAPM, EMH, and Risk Aversion

a. The Capital Asset Pricing Model (CAPM) is a widely used concept in finance. The Model is expressed graphically by the Security Market Line (SML). Within the context of investment, explain how CAPM can be useful to investors. b. Explain Efficient Market Hypothesis (EMH) and the different types of market efficiency. Do stoc

### Net Present Value Analysis of Capital Project

Your company is considering a project (expanding its household product division). Your company is a private company and there are no securities issued and traded in public financial markets. Assume that the project will be 100% equity financed. The initial investment would be 10 million dollar and free cash flows (FCF) for next

### Completing a Horizontal and Vertical Analysis

(Please see the attached files for the full problem information). Prepare vertical and horizontal common-size balance sheet and income statement for Valero. Note: Compute for the most recent THREE years. For the Horizontal the base year is 2010.

### Cash flow scenarios NPV and IRR

Initial investment outlay of \$20 million for equipment only Project and equipment life: 5 years Sales projected to be \$12 million per for 5 years Assume gross margin of 50% (exclusive of depreciation) Depreciation: straight-line for tax purposes Selling, general and administrative expenses: 10% of sales Tax rate: 35% Solv

### Building a model for capital investment decision

Cash Flow valuation Need assistance understanding the problems in excel with formulas.

### Free Cash Flows, EVA and MVA

The question is attached. It asks (in brief): Calculate net operating working capital, total net operating capital, net operating profit after taxes, free cash flow, and return an invested capital for 2013.

### Calculating present/future values of given cash flows

Problem 1 Toadies, Inc., has identified an investment project with the following cash flows. Year Cash Flow 1 \$ 1,400 2 1,520 3 1,605 4 1,655 If the discount rate is 9 percent, what is the future value of the cash flows in year 4? If the discount rat

### Lottery: Discounted Cash Flow Valuation

Assume you won the lottery for \$7M. You have the following two choices in how you want to receive your prize: 1. \$350,000 each year for the next 20 years, with the first check received today 2. One lump sum of \$4M in cash today. Which is the better option?

### Growth Accounting And Neoclassical (Solow) Growth Theory

Using the analytical tools of growth accounting and/or the neoclassical (Solow) growth theory, comment on the following real life questions from Asia's economic development. A. Many developing countries—China and India being notable examples—have pursued in the past policies to curb population growth. What was the rationa

### Company Valuation methods

Company Valuation: Go to http://finance.yahoo.com/q?s=GE and, under Financials, download the income statement, balance sheet, and cash flow statement. GE is one of the holdings in the trust fund. Develop a valuation analysis for the intrinsic value of GE stock. The analysis should incorporate CAPM and the single-stage DDM. R

### Highest Present Value

A financial planner has offered you three possible options for receiving cash flows. You must choose the option that has the highest present value. (1) \$1,000 now and another \$1,000 at the beginning of each of the 11 subsequent months during the remainder of the year, to be deposited in an account paying a 12 percent nominal

### Article Critique: Cash Flow

Please help with an assessment how the article relates to the financial management of a company. Please see attachment to view article. 1. What is the author's focus? 2. What points is the author making? 3. How does the authors points apply to financial management? 4. How does DCF differ from a cash flow analysis? which

### Coupon Bearing Bonds vs. Zero Coupon Bonds

Dan is considering whether to issue coupon bearing bonds or zero coupon bonds. The YTM on either bond issue will be 7.5%. The coupon bond would have a 6.5% percent coupon rate. The company's tax rate is 35%. These are 20 year bonds. 2. How many of the coupon bonds must East Coast issue to raise the \$50 million? 3. In 2

### Role of Economic Value and Replacement Value

Role of Economic Value and Replacement Value Critically evaluate these comments. Please do not wander; concentrate on the issues described by the quotation. - "To me, economic value is the only justifiable basis for measuring plant assets for purposes of evaluating performance. By economic value, I mean the present va

### Importance of Capital Budgeting

I need some assistance analyzing "Capital Budgeting"! What's Capital Budgeting? How do companies use Capital Budgeting and why is Capital Budgeting so important? Response has to be 1,000-words/more (or at least one and a half pages long) with a minimum of 3 references in APA format! Thanks.

### Project Evaluation and Screening Methods

Part 1: Discuss how excessive or exclusive reliance on other screening methods might lead to similar problems? Name some key criteria that should be used in evaluating all new projects before they are added to the current portfolio. What is the effect of poor project-screening methods on a firm's ability to manage its projects

### WACC Analysis

Table 1: Cash Flow Summary Year Project A Project B 0 -30000 -30000 1 15000 12500 2 15000 10000 3 10000 15000 4 10000 15000 If Company XYZ has a WACC of 7% and the two projects are independent, which project would you accept based upon NPV rules? If Company XYZ has a WACC of 26% and the two projects are mutually ex

### Term Modification Without Gain

*E14-21 (Term Modification without Gain—Debtor's Entries) On December 31, 2010, the American Bank enters into a debt restructuring agreement with Barkley Company, which is now experiencing financial trouble. The bank agrees to restructure a 12%, issued at par, \$3,000,000 note receivable by the following modifications: 1.