Question

What aspects of cash flows affect an investment’s value? (why is all of the above the correct answer?)

Timing of the cash flow stream (sooner is better)

Amount of expected cash flows (bigger is better)

Timing of the cash flow stream (sooner is better)

Risk of the cash flows (less risk is better)

All of the above.

Answer 1

The correct option is: - (All of the above)
i.e. the different aspects of cash flows that affect an investment’s value are :

1. Timing of the cash flow stream (sooner is better)

2. Amount of expected cash flow (bigger is better)

3. Risk of the expected cash flows (less risk is better)

A regular stream of positive cash flows generated by the various operating, investing and the financing activities of a company is actually an indicator of the financial viability of that company. A firm which can maximize its long term free cash flow is having better liquidity positions because that means its liquid assets are rising over time. A good steady amount of positive cash flows helps the company to repay its future debts, pay back to shareholders on time, reinvest the earnings on profitable investment opportunities, timely pay all expenses & also provides a buffer during economic downturns thus enabling the co. to save itself from the financial distress.

The basic objective of every company, while preparing its annual reports in a financial year, is to make an honest assessment of the timing, risk and the amount of the cash flows. Hence the cash flow statement is an important part of financial reporting. Most of the companies are interested in knowing the amount of free cash flow that its business has generated over the year. Free cash flow is measured as the amount of operating cash flow left after paying off all the capital expenditures.

While considering an investment proposal, the firm is interested in estimating its economic value. This economic value is determined by the economic outflows (costs) & economic outflows (benefits) related with the investment project. Only cash flows represent these cash transactions.

For taking the capital budgeting decisions i.e. deciding upon the one or more investment projects, the firm employs a no. of capital budgeting techniques like Net present value of the project, Internal Rate of return, Profitability Index of the project etc. Each of these techniques takes into account the time value of money as the project’s expected stream of future cash flows are need to be discounted by their cost of capital or the inflation rate or the prevailing interest rate. The future values of all the cash flows are transformed into their present values after discounting. They are then compared with the initial cash outlay of an investment in order to accept or reject the project. All the techniques like NPV, IRR or PI index choose one project over another depending upon the differences in the timing of their respective expected cash flows.

Amount of cash flows also affect the investment value. Bigger the amount of the expected stream of cash flows from a project, greater is the likelihood that the NPV of that project would be positive and thus that project getting selected. Hence, the amount of the cash flow stream makes a difference between two investment proposals and thereby affecting the selection criteria of one investment over other. Also, if the investment project can generate sufficient amt. of positive cash flows that can again be reinvested at the firm’s cost of capital.

Risk of the cash flows is also an important factor that affects an investment’s value. Because the risk of the expected future stream of cash flows can ultimately affect the estimation of the present value of the annuity stream. All other factors remaining constant, higher the risk of the expected cash flow stream, higher would be the discount rate or the cost of capital and hence, lower would be the present value of the expected cash flow stream. This is for the fact that when an investor expects his/her dividend or interest receipts with near certainty or with less risk of default, he/she will charge lesser rate of return or in other words, the cost of capital for the company will be lower. On the other hand, the earnings with more risk of default will get discounted at a higher interest rate. Hence, depending upon the riskiness of the cash flow stream, an investor adjusts the discounting rate, thereby affecting the present value of the investment.