 Hello and welcome to the session in which we would look at the traditional approach versus the expected cash flow approach when it comes to discounting. This topic has a prerequisite and the prerequisite is knowing how to find the present value of a single amount and the present value of an annuity. In other words, you are comfortable with the concept of discounting, which is finding the present value. This topic is important because it's covered on the CPA exam and it's covered in your intermediate accounting courses. Whether you are an accounting student or a CPA candidate, I strongly suggest you take a look at my website farhatlectures.com. I don't replace your CPA review course. I am a useful addition. I provide alternative backup explanation so you'll be able to understand the material better. Your risk is one month of subscription. I will be able to improve your grade by helping you understand the material better. Your potential gain is passing the exam. Take a look at my website to find out how well or not well your university doing on the CPA exam. I do have resources for other accounting courses such as intermediate, managerial, advanced, governmental, so on and so forth. My CPA supplemental resources are aligned with your backer, Wiley, Roger, Gleam, so it's very easy to go back and forth between your CPA review course and my material. Also, I have all the AI CPA previously released questions. Approximately 1500 CPA previously released exam questions in their original format plus detailed explanation. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation, like this recording, share it with others, connect with me on Instagram, Facebook, Twitter and Reddit. So when do we use the discount? When do we discount cash flows? That's the first thing. When do we use this? Well, generally speaking, we use it to find the fair value of things, either the fair value of an asset, the fair value of a privately held stock, the fair value of an obligation. In other words, what's the obligation for us today? We need to discount the future cash flow. So if we have an investment in a private company, we want to find the stock price of that company. Well, we use discounted cash flow. We might have to value an asset for impairment test, the price of a bond. Many, many assets and many liabilities would require that discounting. For example, if we have a notes receivable, we have to discount it at the present value. Every time we have a future inflow or outflow of cash, it has to be discounted at the present value. Now, how do we, how do we discount? There are two ways to do the discount. The two ways are the traditional method versus the expected cash flow method. And here's what you need to know about those two methods. The traditional method is when you have a single estimate cash flows value. When I mean single, it doesn't mean one. It means single means the estimate. You have one estimate in a sense is in a sense that it is known in a sense that your cash flow is known. You know how much cash flow you're going to be getting under those circumstances. If the cash flow is known, then you would use the risk adjusted rate or simply put the market rate. A good example of this is bonds. When you have a bond, your future cash flows are known. How are they known? Because from the coupon payment every time, every six months, the bond will pay six percent, seven percent, eight percent times the face value. So the interest or the coupon payments are known. Also, when you have a bond, the face value, which is the face value of the bond is already known. So the bond is an example where you would use the market rate. And remember, I told you when you're discounting bond, I believe in the prior session, we looked at how to find the value of a bond. We use the market rate. And the reason we use the market rate, the reason why we do this is because the cash flow is known. So the risk must be in the rate. Therefore, the risk is embedded in the rate, not in the cash flow because the cash flows are known. So every time the cash flow is known, then you would use the market rate because the risk is embedded in the market rate versus the expected cash flow approach. When do you use the expected cash flow approach is when you have a range of possible cash flows. It means you don't know exactly what the cash flow is, what you're going to be doing. You're going to be preparing a probability weighted cash flows. Under those circumstances, what we're saying is the risk of these cash flows is embedded in the probability. So simply put, the risk of the payment, you're already factoring the risk when you do the probability. Therefore, when it comes to the rate, you would use the risk free rate. Risk free rate, that means, first of all, risk free rate is lower than the market rate because the market rate will add inflation, will add premium risk. So it will be lower than the market rate. Why do we use the risk free rate? Because the risk is embedded in the cash flows. So the risk has to be either in the rate itself or in the cash flows. In the first method, the traditional approach, the risk is in the rate itself. In the second approach, the risk is embedded in the probability. So the risk embedded in the variability of the cash flow, a good example will be warranty obligation or warranty liability for a company that sells big screen TVs. Now, there's no ready market for these contracts. So they cannot say, well, we know how much it's going to cost us for these obligations. So what would the company do? They will have to have a range of cash flow with probabilities because they don't know how much it's going to cost them. And we're going to assume a risk free rate of 5%. So here's what's going to happen. In year one, they think that the probability of paying for these warranties could be 4,000, could be 6,000, could be 8,000. The probability of 4,000 is 30%. The probability of 6,000 is 50%. The probability of 8,000 is 20%. Always the probabilities will have to weigh to 100%. Now, we will take 4,000 times 30%, 1,200, 6,000 times 50%, 3,000, 8,000 times 2%, 1,600. So we weigh the probability and the expected cash flow. Notice it's expected. It's not like known like the bond payment, 5,800. In year two, we'll do the same thing. We estimate the cash flow and we estimate probabilities. Year two, 5,000 times 10% chance of us paying 5,000. 7,000, there's a 60% chance. 9,000, there's a 30% chance. And when we add all the probability for year two, it adds up to be 7,400. So for year one, the expected cash flow is 5,800. For year two, the expected cash flow is 7,400. Now, once we know the expected cash flow for year one in year two, we are ready to do the discounting. Which interest rate are we going to use? Well, we're going to use the risk-free rate of 5%. Now, if you are giving the market, you can ignore that. Or if you are giving the premium rate, you can ignore that. Because the variability, the risk of these payments is embedded here. And notice, these are all estimate. Okay, so we are dealing with estimates. So, you know, we are dealing with estimates here. So, we could be wrong. Okay? So, now we are ready to compute the present value of this obligation. Well, what do we do? Well, we have year one and year two and the rate is 5%. For year one, we're going to take the 5,800 and multiply it by the present value factor 9, 5, 2. We're going to take 7,400 multiplied by the present value factor for year two, 0.907. Now, your tables might be a little bit different than mine. You might have more decimal points. That's fine. But this is what you do, 5,800 times 0.95238, which is, we're going a little bit more in decimals, 7,400 times 0.90703. So, the obligation is 12,236. So, for the warranty, we use the expected cash flows. The expected cash flow method, why? Because we had to estimate our future obligation. It was not known, like in the first example. And when that's the case, simply put, we use the risk-free rate. At the end of this recording, I'm going to remind you whether you are an accounting student or a CPA candidate. I strongly suggest you take a look at my website, farhatlectures.com. Once again, I don't replace your beloved CPA review course. I'm a useful addition to your CPA review course. I help you understand the material better. And this is how I can add value. This is how I can add 10 to 15 points to your exam. 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