Customer Footfall Analysis
The retail sector has started using data and analytics in a big way. In general, data and analytics is used extensively by online players in the retail sector. This means that companies like Amazon and eBay have traditionally been collecting data extensively from their customers and have also been using this data to make business […]
Valuation Divergence – Meaning and its Importance
For any startup financing to be successful, the startup company and the investors need to be on the same page about a lot of issues. This is because, in the absence of this understanding, valuation divergence can be a quagmire of ever-escalating tensions between the two parties. One major source of conflict between these two […]
Documents Required for Startup Financing
Setting up a startup company can require a lot of paperwork. It is common for startup founders to spend a lot of their time and effort putting these papers in order. It may seem like a mundane chore and even counterproductive. However, the reality is that the company needs to have all its legal documents […]
Case Study of the Indian Banking and Financial Services Industry using Strategic Tools
Finance is like Oil to the Engine of the Indian Economy As finance is the grease and the oil that keeps the engine of any economy running, the BFSI sector assumes importance in this context. While the post independence era witnessed many large private banks that were either family or community run as well as […]
Investment Banks and Underwriting
The primary function of investment banks is to help their clients raise equity capital. This is often done by initial public offerings. This is where investment banks provide their biggest service i.e., underwriting. Most people have a basic understanding of underwriting. They know that when an investment bank underwrites a share issue, they guarantee to […]
Cash flows vary from project to project. In some cases cash flows will occur evenly over time. There might be payments of similar amounts that will be spread out over a time period at regular intervals.
On the other hand, there might be payments which are irregular and have no pattern whatsoever. The challenge in corporate finance is to value these different streams of cash flows. Here is how this is done:
The present value of a stream of cash flows can be expressed as a lump sum amount. This can be done only after all the expected future receipts are converted to their present day values. The sum of these values is then equal to the value of the expected stream of cash flows. This is exactly how the value of a future stream of payments is derived.
The calculation of the present value of the future stream of money depends upon the nature of the cash flows. If the cash flows are spread out in an even pattern, shortcuts like annuities and perpetuities can be used and the value of large streams can also be calculated very easily. However, if the cash flows are uneven, individual payments have to be discounted to their present value and then all those payments need to be added up.
Now, there are many investments that go on for a period of 10 years, 15 years and so on. The inflation forecast does not remain the same over such an extended period of time. In fact historically, the inflation will change every time there is a change in the business cycle. Hence, for investments over a long period of time, multiple inflation forecasts may be required where different rates are used in different years.
Moreover, in projects where cash flow goes on for multiple years, the uncertainty also increases with increased time. It is a fundamental rule in corporate finance that the farther the expected payments are, the more uncertain they are. This is because over an extended period there might be political, economic or social changes that might affect the cash flows. Hence different rates may be used to discount the cash flows in different years to get a more accurate picture.
Analysts almost always use multiple discount rates to represent the different uncertainties that cash flows in different years have inherent in them. Moreover, the value of the future cash flows is highly sensitive to discount rates. Hence, small changes in the discount rate can bring about big changes in valuation. This, coupled with the fact that discount rates are very difficult to predict in advance makes investing an art rather than a science.
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