Question

Suppose the government proposes a relief package in an urgent attempt to bail out virtually all industries across the board and offset the economic damage unleashed by the 3-month long coronavirus [COVID−19] crisis episode, and indeed, keeps its promise.

Required: By approximately what factor [in the long-run] are businesses likely to discount their negative cash flows, to work out how much is needed to level their current losses?

Further Instructions:

• Remember, this is an essay question, so, please feel free to express yourself as you please. I have allowed 40 lines per attempt (the maximum permitted by the system). All kinds of attachment file types are accepted.

Answer 1

At first we have to understand why the companies are in a negetive cash flow. The reasons may be as follows :

1.If a company has a negative cash flow from investing activities, it will appear on the cash from investing activities section of their cash flow statement.

2.A company might have a negative cash flow from investing activities because management is investing in long-term assets that should help the company's future growth.

3.To decide if a company's negative cash flow from investing activities is a positive or negative sign, investors should review the entire cash flow statement for more information.

Now, as we know the companies have to discount the cash flows .

discounted Cash flow essentially attempts to estimate the current value of a company and its shares by projecting its future free cash flows (FCF) and “discounting” them to the present with an appropriate rate such as the weighted average cost of capital (WACC). Although discounted Cash flow is a popular method that is widely used on companies with negative earnings, the problem lies in its complexity. An investor or analyst has to come up with estimates for (a) the company’s free cash flows over the forecasted period, (b) a terminal value to account for cash flows beyond the forecast period, and (c) the discount rate. A small change in these variables can significantly affect the estimated value of a company and its shares.

For example, assume a company has a free cash flow of $20 million in the present year. You forecast the FCF will grow 5% annually for the next five years and assign a terminal value multiple of 10 to its year five FCF of $25.52 million. At a discount rate of 10%, the present value of these cash flows (including the terminal value of $255.25 million) is $245.66 million. If the company has 50 million shares outstanding, each share would be worth $245.66 million ÷ 50 million shares = $4.91 (to keep things simple, we assume the company has no debt on its balance sheet).

Now, let’s change the terminal value multiple to 8, and the discount rate to 12%. In this case, the present value of cash flows is $198.61 million, and each share is worth $3.97. Tweaking the terminal value and the discount rate resulted in a share price that was almost a dollar or 20% lower than the initial estimate.