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Discounted Cash Flow Analysis
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The answer to the question "who cares" is " everyone should care". Firstly, if a flow fails Descartes' rule of signs test it will be because contained in the flows are negative outflows after the first initial investment outflow. That is what causes the sign changes of the rolling forward totals. The first question that should come to mind is "Where will these negative subsequent flows come from? " The second question is what cost, if any, should be introduced to the analysis and how will it be introduced.?
Let's try to answer the first question and watch what happens. Where is the money going to come from? There are two main sources of the money, one would be from within the transaction, and the other would be from outside the initial transaction, such as a loan or additional investment. Let's look at the source from within the transaction flows first. In many instances the cash flows we are examining will have sufficient prior inflows to adequately meet the subsequent required outflows. In those cases we could set aside some of the inflowing money in sufficient amounts to meet the subsequent required outflows. The transaction will be fully self-supporting and all outflows, after the initial investment, will be expensed to the transaction by being part of the net flows. The set-aside money needed to pay out the negative periods is conceptually provided for by putting the money in an account called a sinking fund. A physical fund may not be set up. The savings may be viewed as being held by the parent company. In that case it is valued at the parent's marginal cost of borrowing (or some other agreed rate). The earnings on the fund, real or conceptual, would be the interest rate paid by the institution holding the money. If it is in a bank, then it is at some bank savings rate, if used by the parent, then it should be the parent's marginal cost of funds. The fund money can be viewed as an offset to existing debt until returned to the transaction by the parent company. The governing limits of the sinking fund are usually to put aside just enough money to meet the negative flows. Taking more money than minimally needed and placing it in a savings account will usually be detrimental to the profitability of the transaction since the transaction is presumed to be earning more than can be earned at the sinking fund institution, all other things being equal. If this is done precisely, it will have the effect of smoothing out the cash flow's swings from positive to negative and eliminate the multiple sign change issue introducing zero cash flows in some of the periods that were formerly negative. More importantly, the transaction model is now pictured and set up as a logical flow of cash that defines all of the sources of the flows, income and expenses associated with the model. Since all of the funds are from within the transaction after the initial investment, the profitability (or lack thereof), as measured by the rate of return within the flows, is all-inclusive recognizing all costs and income associated with transaction. By addressing the issue of "where does the money come from" we have solved three issues: where is it from, what is the cost, and is the rate so determined reliable and unique. For the case where the money comes from within we have solved it all. Voila! In case anyone hasn't noticed, we also explained what an "Extended Yield Analysis Method " is and why it is needed. Simply put, it is needed to present a logical, all inclusive, verifiable and complete flow model and develop a unique and implicit rate from an otherwise incomplete, illogical arbitrary multiple rate potential flow scenario.
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June 19 2015 page 2
Discussion ....Extended Yield Methods
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