Downsides and DCF: Valuing Biased Cash Flow Forecasts

Introduction

Under normal circumstances, when provided with income and cash flow statements it essential to make cash flow projections using historical data. Apart from historical data, it is possible for an organization to make projections for its cash flows by taking into consideration other factors such as the industry in which the firms falls in. Theoretically, when the cash flow projections are to utilize discounted cash flow valuation, then it is a requirement to have its forecasts being equal or averagely equal to cash flows. When it comes to actual forecasting, there are situations whereby top management of organizations come up with a forecast that are upwardly biased estimates from cash flows expected by historical data. This research paper focuses on ways in which the financial managers can identify and be able to find remedies for biased cash flow estimates. The paper will also address limitations of DCF method. DCF formula should be modified to ensure that it can value all cash flow forecast that has been valued upwards in a biased way. Organizations have been taking into consideration methods that can help in adjusting DCF formula to correct inaccurate forecasts. A publication made by Jim Poterba and Larry Summers (1995) provided a list of US companies that adjusted its DCF formula.

Is your time best spent reading someone else’s essay? Get a 100% original essay FROM A CERTIFIED WRITER!

Save 25%

Manager rationale for bias cash flow estimates

Sahlman (2009) says that for every organization to value its capital expenditure, then it should be able to estimates all the cash flows for investment projects at a given time. Management argues out that bias cash flow estimates for projects whether intentional or unintentional are always aimed at ensuring that resources are allocated to those projects that increase shareholders wealth. Managers will always have a rationale as to why they come up with biased cash flow estimates. A manager can underestimate costs associated with projects that the manager would intend to have an expansion of its resource base. There are high chances that a manager will receive a huge part of an organization's resources if their projects' cash flows are upwardly valued (Kaplan & Ruback, 1995). There are instances where firms compensate their managers basing on jobs responsibilities handled by the client. Managers will always be tempted to put more control on such areas while other sections of the firm are ignored.

The second reason for bias cash flow estimates is that there are firms that compensate their employees by the firm's objectives. Management by objective is the name of this kind of scheme used in compensating employees. Proposed projects, which have a high likelihood of being rejected due to high cash flows, might tempt the manager to reduce the projects cash flows. According to (Bollen & Busse, 2001) reducing cash flows for such projects will ensure that the project continues to receive funding. The investors in the firm will view the project as a good investment. Funding such project will ensure that the manager is receiving compensations. The manager in charge of the project will be faced will less pressure once the progress of the project is ongoing. The manager will not be facing pressure from investors who would want certain performance standard to be met. Downward bias of cash flows by the management will give way for cushioning in case the management performance is not optimal. The manager will be able to achieve the objectives that were initiated at the beginning of the project. Thirdly there is a case of short-run trade-offs that might arise. Firms have both revenue and income- based goals this is according to (Roychowdhury 2006). A good example is during the end of year financial reporting period whereby managers might be tempted engage in biased cash flow estimates in order achieve revenue and income goals.

Limitations of DCF and how it affects project choice

The DCF model is faced with high chances of being affected by changes in assumptions laid down when using the model for valuation. In case of slight changes to its forecasts, there are high chances of a wide variation on DCF valuation. It, therefore, implies that the fair value has a high chance of inaccuracy. The terminal value will automatically result in a perpetual growth rate (Kulatilaka & Marcus, 1992). In every firm, the terminal value always plays a critical part of the overall company value. It, therefore, means that the perpetual growth rate will render the DCF model's validity. There are loopholes that make it possible to manipulate DCF analysis. A manager can easily input values that suit them to achieve their objectives. An economist point of view cannot detect changes that can be made on DCF analysis. A good example is when there is an introduction to changes in WACC or the perpetual growth. There are no professional tools to estimate the accurateness of inputs in a DCF model.

The second weakness of DCF is that it can be used only if we first predict cash flows or earnings into the future. It is evident that it is difficult for firm's management to easily predict what the company might earn in the following financial year. When we borrow from the macroeconomic point of view, it is always hard to make predictions for GDP. Just like macroeconomic predictions, it is also difficult to make future projections for cash flows for firms. It is, therefore, to admit that as professionals and management it is not viable to make valid predictions by historical data. In any case, a slight error will automatically result in a huge difference in DCF valuation (Truong, Partington & Peat, 2008).

Potential behavioral and methodological remedies

The real options model is a remedy to DCF model. Expected cash flows and its missing components are modeled. The first part of the model is to illustrate the necessary formulas that are required when to be made on DCF formula. The illustration will show how in the first instance required adjustments will result in a reduction in the forecasted cash flows. The other part of the illustration is to introduced adjustments that will result in a decrease in forecasted cash flows as the discount rate increases.

Adjusted discount cash flows

The first part of the model derives an adjusted discounted cash flow formula that is of importance when making a forecast of cash flows that are not expected. The second part of the model is to come up with a formula that illustrates how DCF fail to assign a probability of projects going downside instead of as expected (Demirakos, Strong,& Walker,2004).

Temporary omitted downside

Let as assuming that the forecasted cash flows do not change. Let the forecasted cash flow be X for all the periods. The forecasted cash flow will not qualify as expected cash flow. The reason is that X will not include chances of a downside. Let take the probability of such a downside to be l; then, in this case, the expected cash flow should be zero. Each period will, therefore, have a chance of occurrence of downside being equal. An occurrence of downside will therefore not influence all future cash flows. In this case, the downside will be temporary.

The expected cash flow for the first period will be illustrated below.

E x(X)1 = (1l)X + ( )0 l = (1l)X. and for the second period the formula is

E x(X)2 = (1l)(1l)X + (1ll)(x )0 + ( )(1l l)X + (X )( X)0ll

= (1l) (1 [ l l) X +( ) X ]

= (1l) X.

From the formulas derived above it illustrate that the cash flows do not have an impact on its cash flows. The cash flow is going to remain to be X(1- l). The cash flows are discounted to find the present values of cash flows.

The formula for expected cash flows is denoted below

In this case whereby the cash flow is zero, then its unadjusted discount cash flows will always be lower. It, therefore, implies that in a case where there is a 5% probability of cash flow to be zero then, in that case, the downside will remain to be constant in all periods. Therefore, the present value is going to be 5% less of the adjusted discounted cash flow.

Permanent omitted downside

Assuming that the forecasted cash flows remain the same then the expected cash flows will not be equal to forecasts. The permanent omitted downside is different from temporary downside since the probability for each duration is considered independent. The expected cash flows of its appropriate risk-adjusted discount rate are going to be.

It is therefore evident that adjusted DCF formulas reduce the cash flow forecast on the probability of downside.

Impact of discounted cash flow adjustments

Let us assume the constant cash forecasted cash flow at a discounted rate of 5%. The omitted downside occurrence to be 5% and its cash flow to be zero. The present values are a percentage of unadjusted DCF. Let the adjusted DCF of temporary downside be 90%. The 90% is considered unadjusted value because it reduces the forecasted base cash flow. The adjusted DCF when absorbing downside will be 61% of its unadjusted DCF. The DCF is for ten years having constant cash flow dropping to 48% after 30 years.

x

255435694213 Unadjusted DCF = = = 10x.

k10%

Adjusted DCF = x(1l) = .9x = 9x,

k 10%

The final analysis, therefore, indicates that while for a temporary omitted downside it will have same impact on its value. This is when taking into consideration the increase of its annuity. Therefore it implies that an asset is undergoing valuation with a long life, then it is good to provide specifications as to whether it is a temporary downside or permanent downside( Minton & Schrand, 1999).

Alternative valuation methods to address biased cash flow forecasts

The internal rate of return (IRR)

When it comes to capital budgeting for project analysis, then the basic rule is to accept a project if the IRR is greater than its cost of capital. The project is rejected if its IRR is less than the project. Below is an example of IRR of a project. The IRR is 12%. The project will, therefore, be accepted if the discounted cash flow model is less than 12%. An advantage of using IRR is it acts as a basis where other projects can be assessed while referring to the firm's capital structure. The IRR model also makes it easy for the company to make a comparison of projects depending on its returns after its investments (McAuliffe, 2006).

The cons of using IRR as a tool to make cash flow forecast is this method do not provide the actual value of the project. It simply provided a basis depending on an organization's cost of capital. This method also does not make it possible to compare mutual projects. The management, therefore, will find it difficult to decide on the best project that should be accepted by the firm.

Payback Period

Payback period is referred to the period it takes for an invested project to recover all the costs incurred(Allen et al., 2006). While most capital budgeting methods take into consideration time value for money, the payback period, on the other hand, does not consider the time value of money. The payback period is simply the number of years it will take an investor to recover their money.

Example of a payback period calculation

Laico ltd has received a proposal from a manager, asking to spend $1,500,000. The cash in flows is shown below.

The projection for total cash flows for five year period is $2000000 and an average of 400, 000 per year.

= 15000000/400000 = 3.75

The payback period is 3.75 years...