In: Finance
Briefly describe the three key inputs –cash flows, timing, and the required rate return—to evaluation process. Does the valuation process apply only to assets providing an annual cash flow? Explain
Cash flows in an evaluation process refer to the free cash flow (FCF). In an evaluation process an asset or a company is evaluated by developing an estimate that is based on its future cash flows. The cash flows are used to determine the value today based on the projections with regards to amount of money that will be generated in future.
Timing of cash flows is an important aspect as it helps to incorporate the principles of time value of money. Cash received in different points of time has different values and cash received today is more valuable than cash that will be received tomorrow.
Required rate of return is used to discount the cash flows of future to align them at a single point in time today. Thus cash received after 1 year will have a present value = cash flow amount/(1+required rate of return)^1 and cash received after 3 years will have a present value = cash flow amount/(1+required rate of return)^3.
No, the valuation process does not apply only to assets providing an annual cash flow. It can even apply to assets with intermittent cash flow or even to assets having a single cash flow over a period of time. This is because the valuation process simply turns cash flow of future to today’s value. The future cash flow can be in any form – annual, bi-annual, intermittent, only one cash flow over the entire life of the asset etc.