Discounted cash flow (DCF)
For a working spreadsheet example of discounted cash flow calculations, download the free financial metrics tool (click here).
The DCF is a cash flow summary that has been adjusted to reflect the time value of money. It is an important criterion in evaluating or comparing investments or purchases; other things being equal, the purchase or investment associated with the larger DCF is the better decision. Almost every manager trained in finance will ask to see cash flows on a discounted and non-discounted basis.
DCF makes use of the Present Value concept, the idea that money you have now should be valued more than an identical amount you would receive in the future Why? The money you have now you could (in principle) invest now, and gain return or interest, between now and the future time. Money you will not have until some future time cannot be used now. Therefore, the future money’s value is Discounted in financial evaluation, to reflect its lesser value.
What that future money is worth today is called its Present Value, and what it will be worth when it finally arrives in the future is called not surprisingly its Future Value. Just how much present value should be discounted from future value is determined by two things: the amount of time between now and future payment, and an interest rate. (For rough estimates, think of the interest rate as the return rate we would expect if we had the money now and invested it). For a future payment coming in one year:
Present Value = (Future Value) / (1.0 + Interest Rate)
What is the present value of $100 we will not have for a full year? If we use an annual interest rate of, say, 10%, then
Present Value = ($100)/(1.0 +0.10) = $90.91
What is the present value if the payment were not coming for 3 years? For multiple periods, the present value calculation becomes:
Present Value = (Future Value) / (1.0 + Interest rate)n
The exponent "n" is simply the number of periods, or years, in this case 3. The present value of $100 to be received in 3 years, using a 10% interest rate is thus:
Present Value = $100 / (1.0 +0.10)3 = $100 / (1.1) 3 = $75.13
"Periods" for these calculations can actually be years, months, or any other time. In any case, be sure that the interest rate represents interest for that period. (When calculating DCF on a monthly basis, for instance, use the annual interest rate divided by 12).
As the payment gets further into the future, its present value drops. Also, as you can see, increasing the interest rate would further reduce the present value. Only where interest rates were assumed to be 0 (an economy with no investment possibility and no inflation) would present value always equal future value.
Now consider two competing investments in computer equipment. Each calls for an initial cash outlay of $100, and each returns a total a $200 over the next 5 years making net gain of $100. But the timing of the returns is different, as shown in the table below (Case A and Case B), and therefore the present value of each year’s return is different. The sum of each investment’s present values is called the Discounted Cash flow, or DCF. Using a 10% interest rate again, we find:
Timing |
Case A Net Cash Flow |
Case A Present Value |
Case B Net Cash Flow |
Case B Present Value |
| Now | -$100.00 |
-$100.00 |
-$100.00 |
-$100.00 |
| Year 1 | +$60.00 |
+$54.54 |
+$20.00 |
+$18.18 |
| Year 2 | +$60.00 |
+$49.59 |
+$20.00 |
+$16.52 |
| Year 3 | +$40.00 |
+$30.05 |
+$40.00 |
+$30.05 |
| Year 4 | +$20.00 |
+$13.70 |
+$60.00 |
+$41.10 |
| Year 5 | +$20.00 |
+$12.42 |
+$60.00 |
+$37.27 |
| Total | $100.00 |
NPV=$60.30 |
$100.00 |
NPV=$43.12 |
Comparing the two investments, you can see that the early
large returns in Case A lead to a better total net present value (NPV) than the later
large returns in Case B. Note especially the Total
line for each present value
column in the table. This total is the net present value (NPV) of each
"cash flow stream." When choosing alternative investments or actions,
other things being equal,
the one with the higher NPV is the better investment.
In brief, a DCF view of the cash flow stream should probably appear with a business case summary when ...
- The business case deals with an "investment" scenario of any kind, in which different uses for money are being compared
- The business case covers long periods of time (two or more years)
- Inflows and outflows change differently over time (e.g., the largest inflows come at a different time from the largest outflows)
- Two or more alternative cases are being compared and they differ with respect to cash flow timing within the analysis period
For a working spreadsheet example of discounted cash flow calculations, download the free financial metrics tool (click here).
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