Discounted Cash Flow Analysis

Macmillan and Grunski Consulting

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DISCOUNTED CASH FLOW ANALYSIS

Directed

Sandra Macmillan was born and raised in Orlando, Florida, and joined the Peace Corps after receiving her bachelor’s degree in Economics. While in the Peace Corps she met Sam Soule, whose uncle

ran Bolton, Soule, and Martinez Inc., a regional brokerage firm in Seattle. He mentioned that his

uncle was always interested in hiring competent and hard-working people with broad vision. He suggested that she contact his uncle after completing her service. When she returned to the United

States, she wanted a change in climate and accepted a job with Sam’s uncle. She immediately

became familiar with the operations of the firm and quickly identified better methods of accomplishing her work. This allowed her to accept more and more responsibility. After several years,

she realized that she needed an MBA to provide her with the skills that would take her to the next

professional level. At her request, she moved into a part-time position so that she could complete her

MBA in Finance at the University of Washington. After graduation she was promoted to a senior

analyst with the firm. She began working closely with Betsy Grunski, a Stanford MBA who had been

working as a financial analyst with the company for just over a year. Although Sandra enjoyed her

work and the firm had been good to her, she wanted to open a financial consulting firm in San Francisco. After five years, Sandra managed to save enough in commissions to realize her goal. She

convinced Betsy to become a partner and move to San Francisco to open their own financial firm,

Macmillan and Grunski Consulting.

Macmillan and Grunski Consulting provides financial planning services to upper middle-class

professionals. Basically, the firm provides consulting services in the areas of income tax, investment

and estate planning, insurance and employee benefits advising, and financial planning for small, family-owned businesses. The tax and legal issues faced by the company are not generally complex.

Therefore, the firm does not have a tax lawyer or CPA on its staff and hires outside experts when

needed.

Business has been excellent and Sandra and Betsy have been working overtime to handle the

load. Rather than getting on top of the workload, however, they continue to attract new clients.

Sandra has recently turned away several potential customers because she didn’t think that the firm

could offer them the high degree of personal service upon which the company’s reputation is based.

As a permanent solution, she is talking to career resource center personnel at several universities.

She hopes to hire a finance major who can start work immediately after graduation, but that is still

several months from now. Also, the company has a significant amount of paraprofessional work that

can be turned over to a lower level employee with an understanding of basic financial concepts.

Copyright © 2000. The Dryden Press. All rights reserved.Sandra believes that Mary Somkin, the firm’s top secretary, can be trained to handle some of

these financial analysis duties. Mary has been taking night courses in business at a community college and believes that she can handle increased responsibilities. Sandra has a great deal of faith in

Mary and would like to keep her with the company. She has been with the firm from the very beginning; her great personality and sound work ethic have contributed substantially to the firm’s success.

Still, Sandra knows that there is little room for error in this business. Customers must be confident

that their financial plans are soundly conceived and properly implemented. Any mistakes create

instant mistrust and the word spreads quickly.

To make sure that Mary has the skills to do the job, Sandra plans to give her a short project. As

far as Sandra is concerned, the single most important concept in financial planning, whether personal

or corporate, is discounted cash flow (DCF) analysis. She believes that if Mary has solid skills in this

area, she will be able to succeed in her expanded role with minimal supervision. The basis for the

project is an actual analysis that Sandra is currently working on for her clients. The clients have

$18,000 to invest with a goal of accumulating enough money in six years to pay for their daughter’s first year of college at a prestigious Ivy League school, which is estimated to be $35,000. The

clients have directed Sandra to evaluate only fixed interest securities (bonds, bank certificates of

deposit, etc.) since they do not want to put their daughter’s future at risk.

One alternative is to invest the $18,000 in a First National Bank certificate of deposit (CD) currently paying about 8.4 percent annual interest. CDs are available in maturities from six months to

ten years, and interest can be handled in one of two ways: the buyer can receive interest payments

every six months or reinvest the interest in the CD. In the latter case, the buyer receives no cash interest payments during the life of the CD, but receives the accumulated interest plus the principal

amount at maturity. Since the goal is to accumulate funds over six years, all interest earned would be

reinvested. However, in order to fully understand the issues involved, Sandra believes the analysis

should start with a one-year example and then move to the six-year investment horizon.

The clients are also interested in how interest levels and timing affect the investment.