Question

Please, write a 2 paragraph essay. In your own words, address the topic below. Use any outside sources you consider relevant.

An investment is worth the present value of its future cash flows. Since a company is a series of investments, it is worth the total present value of all cash flows generated by the firm.

Answer 1

The value of a business can be computed as the present value of its future cash flows. Firstly the future cash flows need to be estimated and there after they are discounted at a suitable rate of interest which is generally the weighted average cost of capital of the business. This represents the opportunity cost of the funds generated. The discounted value of the future cash flows represent the present value of the future cash flows that are generated by a particular business.

Free cash flows represent the cash generated by a company after cash outflows which will help the company to support its operations and maintain the assets. At times the company may not pay dividend to the shareholders. Specially in these cases the free cash flow method is applied to value the company. The growth factor should also be taken into account at the time of valuation of the company. There may be a constant growth or multiple growth periods involved and the free cash flows should be computed accordingly. Hence the free cash flow method is useful for calculating the present worth of a particular company even if it does not pay dividends.