Question

In: Accounting

* Discuss the two variables that must be considered whether you are using the present value...

* Discuss the two variables that must be considered whether you are using the present
value of cash flow approach or the relative valuation ratio approach to valuation. Why
are these variables relevant for either valuation approach?

*Discuss the contention that differences in the performance of various firms within an
industry limit the usefulness of industry analysis.

Apa referencing required

Solutions

Expert Solution

1.Factors Affecting Net Present Value.

The major factors affecting present value are the timing of the expenditure (receipt) and the discount (interest) rate. The higher the discount rate, the lower the present value of an expenditure at a specified time in the future.

The cash flows in net present value analysis are discounted for two main reasons, (1) to adjust for the risk of an investment opportunity, and (2) to account for the time value of money (TVM).

The first point (to adjust for risk) is necessary because not all businesses, projects, or investment opportunities have the same level of risk. Put another way, the probability of receiving cash flow from a US Treasury bill is much higher than the probability of receiving cash flow from a young technology startup.

To account for the risk, the discount rate is higher for riskier investments and lower for a safer one. The US treasury example is considered to be the risk-free rate, and all other investments are measured by how much more risk they bear relative to that.

The second point (to account for the time value of money) is required because due to inflation, interest rates, and opportunity costs, money is more valuable the sooner it’s received. For example, receiving $1 million today is much better than $1 million received five years from now. If the money is received today, it can be invested and earn interest, so it will be worth more than $1 million in five years’ time.

2. Disagree. Although studies have shown a significant dispersion of individual firm performance within a given industry, they also found that the industry component could partiality explain individual firm performance. Although the strength of the industry component varies among industries, Industry analysis is an important step before proceeding to the company analysis. The important implication is that individual company analysis would be relatively more important for industries where individual company returns are widely dispersed. The point is the dispersion among companies within industries indicates a need for company analysis after industry analysis.

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