Question

In finance, the price (value) of any cash flow-producing asset is the present value of its expected cash flows. Using a typical common stock or corporate bond as an example, describe the discounted cash flow method and how you would consider risk in the calculations.

Answer 1

GIven statement states that the value of cash flow producing asset is the Present value of its expected cash flow.

First, to provide explantion on the background of the statement we will understand what is Cash flow producing asse- that is any asset which brings you or earns you cash during a certain period may be short or long term.General example of that are Bonds and stocks, because even when you dont make any hardwork or put any efforts to earn , these assets brings you in cash flow bby means of Interest in bonds / Dividend in stocks.

To answer the question, we need to describe what is discounted cash flow with an example, either common stock or corporate bond.Here iam choosing corporate bond as example to proceed further.

Okay! First let us understand what is discounted cash flow-Discounted cash flow is a method of analysis used to identify the investments value based on its future cash flow.In other words, we can say that as DCF is a method to analyse or to provide an estimate of the investments, on the basis of how much it will earn in furture i.e its future cash flow.

Here we are illustrating it with corporate bond.Let me illustrate it as follow. Assume X corporation ltd, desires of investing in bonds, so it uses the DCF method to analyse the value of investment to be made in bonds with respect to its future cash flow which the bonds will earn as interest. Now, the company uses DCF for 2 reasons majorly, one is like as we stated above, it will identify what will be the future cash flow because of the investment made, that is what will be the return te company will earn because of such investment. On the oter hand, it also identifies the risk associated on the investment made in the bonds.For this , the company makes use of discounted cash flow method.

Okay!the next question will be how do we use DCF?TO be sort and clear, the Discounted cash flow method involves 3 steps,

First, it will estimate the future cash flow

Secondly,identify the Discount factor

And finally identify the Discount free cash flow of the firm.

To identify the cash flow, we can use the formula, Cash Flow X (1 + Long-Term Growth Rate)n

To identify the discount factor, it is 1 / (1 + Discount Rate)n

where,n= number of years

And the final will be the product of cassh flow and discount factor.This is the common for DCF.

With reference to corporate bonds, under DCF - the value of bonds usually differ with the interest rate that prevails.

Bond Price is the amount that the investor is ready or willing to pay actually for the bond

DCF for a bond valuation can be done by using the common formula,

DCF= (CF1(1+r)^1)+(CF2(1+r)^2)......CFn+(1+r)^n

For example, we can take that the bonds we are to invest$100 will have a cash flow of 5% compounding,

that means in the first year we get 5 $ in the second year it will be , 5.25 like wise, ere the DCF will be like,

DCF= 5/(1+0.05)^1+5.25/(1+0.05)^2........CFn(1+r)^n.

The companies use the DCF to make investment decisions, and it is not desirable for a firm to use DCF when its financial position is unstable.

To begin with the second part of the question , that is RISK- DCF also focuses on identifying the risk along with the calculation of return.

Here, the basic concept is like with high risk comes higher profits, and low risk gives low return.

the risk adjusted Discounted cash flow of a bond will be higher than the normal DCF because the risk factor has been adjusted here.Similarily tere are possible for losses also in te high risk bonds.

Thus, DCF ia one of the best methods to identify the return expected on a investment to be made and also to identify the risk based on such investment.