Question

Evaluate the advantages and disadvantages of alternatives to discounted cash flows.

Describe a scenario in which you would recommend one method as being more effective than others. Draw from your professional experience and/or additional research and provide a rationale for your recommendation.

Answer 1

Discounted cash flow valuations are one pricing system that investment professionals use to determine the value of stocks. Proponents of this valuation method argue that you can get an accurate picture of a firm's true value only if you estimate its current and future cash flow.

Discounted Cash Flow Alternatives

As companies continue or expand their operations, they are faced with possible capital budgeting projects that are to be evaluated to ensure that they meet the management's acceptance criteria as to profitability, payback, and other critical concerns.

Advantage:--

A big advantage of the discounted cash flow model is that it reduces an investment to a single figure. If the net present value is positive, the investment is expected to be a moneymaker; if it's negative, the investment is a loser. This allows for up-or-down decisions on individual investments. Further, the method allows you to make choices among significantly different investments. Project each investment's cash flows, discount them to present value, add them up, and compare them. The one with the highest net present value is the most profitable alternative.

Disadvantage:-

• Discounted cash flow valuation is only as good as the estimates that go into it. If those estimates are flawed, the net present value will be inaccurate, and you may make bad investment decisions. The model offers multiple opportunities for error. All projected cash flows are just that: projections. They're estimates -- educated guesses. Plus, the discounting formula used to convert those cash flows to present value includes another estimate -- the discount rate, which is the rate by which you assume a certain sum of money will change in value over time.

• The discounted cash flow method produces a number in isolation. But you'd be wise not to look at that number in isolation. Say you're trying to estimate the value of a company. You can use the discounted cash flow method to come up with a value for the company. You can test how realistic that number is by performing a reality check, looking at how the value derived from discounted cash flow compares with the company's market capitalization; with the book value of the company as shown on the balance sheet; or with the value of similar companies.

==> Scenario planning, also called scenario thinking or scenario analysis, is a strategic planning method that some organizations use to make flexible long-term plans.

In the past, strategic plans have often considered only the "official future", which was usually a straight-line graph of current trends carried into the future. Often the trend lines were generated by the accounting department, and lacked discussions of demographics, or qualitative differences in social conditions.

Scenarios planning starts by dividing our knowledge into two broad domains: (1) things we believe we know something about and (2) elements we consider uncertain or unknowable. The first component – trends – casts the past forward, recognizing that our world possesses considerable momentum and continuity. For example, we can safely make assumptions about demographic shifts and, perhaps, substitution effects for certain new technologies. The second component – true uncertainties – involve indeterminables such as future interest rates, outcomes of political elections, rates of innovation, fads and fashions in markets, and so on. The art of scenario planning lies in blending the known and the unknown into a limited number of internally consistent views of the future that span a very wide range of possibilities.

Numerous organizations have applied scenario planning to a broad range of issues, from relatively simple, tactical decisions to the complex process of strategic planning and vision building.