www.itilhelp.com Discounted Cash Flow (DCF) Explained Introduction Discounted Cash Flow (DCF) is used by organisations as an investment appraisal technique which takes into account both the time value of money and, the total cash flows over a project’s life. It is often, therefore, frequently argued that DCF is a superior method of investment appraisal than ROI. The purpose of this paper is to explain DCF.

DCF The term `discounted cash flow’ identifies two important characteristics of the method:1.

The timing of cash flows is taken into account by a process of discounting. The effect of this is to give a bigger value per £1 for cash flows that occur in earlier years. For example, £1 earned after one year will be worth more than £1 earned after two years, which in turn will be worth more than £1 earned after 10 years. Discounting involves selecting a discount rate that reflects an individual’s or an organisations time value of money.

2.

Cash flows are accounted for in the appraisal, rather than cost and revenues as used in ROI. The reason for this is that in accounting for cash flows, receipts and payments are recognised when they occur. This is not the case for the majority of costs and revenues when employing accruals accounting. For example, the cost of an investment will be accrued over the life of the investment employing a system of depreciation. In contrast, the whole of the cost of the

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www.itilhelp.com investment when accounting for cash flows would be recognised when the payment is made. In taking account of the time value of money it is critical that the cost and benefits of an investment are identified when they are actually paid and received, rather than when they are identified as a debt or liability or, are accrued.

The Process of Discounting Discounting is compounding in reverse. The following example explains:

Example: ACME Internet invests £10,000 to earn a return of 10% (compound interest). The value of the investment with the interest will accumulate as follows:After 1 year £10,000 x (1.10) = £11,000 After 2 years £10,000 x (1.10)² = £12,100 After 3 years £10,000 x (1.10)³ = £13,310 The above is compounding. The formula for the future value of an investment including accumulated interest earned after n time-periods is: FV=PV(1+r)ⁿ Where;

FV is the future value of the investment with interest. PV is the initial or present value of the investment. r is the compound rate of return (reflecting the time value of money) per time period. ⁿ is the number of time periods; normally measured in years.

Discounting converts future values to present values and is the reverse of compounding. For example, if an organisation expects to ear a compound

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www.itilhelp.com rate of return of 10% on its investments, how much would it need to invest now (the present value of the future sum) to have an investment of: £11,000 after 1 year? or £12,100 after 2 years? or £13,310 after 3 years?

Answer: After 1 year, £11,000 x 1/1.10 = £10,000 After 2 years, £12,000 x 1/(1.10)² = £10,000 After 3 years, £13,310 x 1/(1.10)³ = £10,000 The discounting formula to calculate the present value of a future sum of money at the end of n time periods is: PV = FV 1 (1+r)ⁿ Discounting can be applied to both money receivable and also to money payable at a future date. By discounting all payments and receipts from a capital investment to a present value, they can be compared on a common basis at a value which takes account of when the various cash flows will take place.

Example : Use of DCF in Investment Appraisal ACME Internet Inc., is looking at an investment opportunity which will generate £40,000 after 2 years and another £30,000 after 3 years. Its target ROI (return on investment) is 12%. The present value of these cash inflows is: Page 3 of 6

www.itilhelp.com Year 2

Cash flow

Discount Factor

Present Value

12%

£

1

31,880

40,000

(1.12)² 3

30,000

1

21,360

(1.12)³ Total PV

53,240

The present value of the total future inflows of cash, discounted at 12% is £53,240. This means that if ACME Internet Inc., can invest now to earn a return of 12% on its investments, it would have to invest £53,240 now to earn £40,000 in 2 years’ time plus £30,000 in 3 years time.

Using DCF to Appraise Investments (& NPV) Net Present Value Net Present Value (NPV) is the value obtained by discounting all cash outflows and inflows of an investment by a chosen rate of return; sometimes referred to as the `cost of capital’. The present value of cash inflows minus the present value of the cash outflows is the NPV. Therefore, if the NPV:-

Is positive, it means that the cash inflows from the investment will yield a return in excess of the cost of capital, and, therefore, the investment project should be undertaken – the business can pay its

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www.itilhelp.com providers of capital the necessary returns and still have cash to employ in the business. -

Is negative, it means the cash inflows from the investment will yield a return less than that required to satisfy the providers of capital, and, therefore, the investment should be rejected.

-

Is exactly zero, it means that the investment has generated exactly the required returns to satisfy the providers of capital, without any surplus to employ in the business.

The discount factor calculated using the formula 1/(1+r)ⁿ can be more easily determined by using discount tables.

Example ACME Internet Inc., are considering a capital investment, where the estimated cash flows are:

Year

Cash Flow £

0 (i.e., now)

(100,000)

1

60,000

2

80,000

3

40,000

4

30,000

The business’s cost of capital is 15%. What is the NPV of the proposed project and should it be undertaken?

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www.itilhelp.com Answer: Year Cash flow £

Discount factor

Present value

at 15%

£

0

(100,000)

1.000

(100,000)

1

60,000

0.870

52,200

2

80,000

0.756

60,480

3

40,000

0.658

26.320

4

30,000

0.572

17,160

NPV

56,160

In the answer above, the value of cash inflows exceeds the present value of cash outflows by £56,160. This means that the project produces a DCF yield in excess of 15%. The project should therefore be undertaken. A Microsoft Excel 2002 spreadsheet is available for download from http://www.itilhelp.com; DCF and NPV Spreadsheet.xls

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