Revision as of 21:21, 19 February 2023

Abstract

Net Present Value (NPV) and Discounted Cash Flow (DCF) are two of the most commonly used financial metrics for evaluating projects and investments opportunities. Both these concepts operate under the time value of money principle, which assumes that money is worth more today than it is in the future. ^[1] The mentioned metrics can be used together when making a project, program or portfolio decision but they are not the same. Whereas the DCF analysis determines how much projected cash flows are worth in today’s time, the NPV express the net return on the investment after accounting for startup costs. ^[2]

Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. ^[3] As it takes into consideration the time value of money and provides a concrete number (rates of return for the investment) that managers can use easily to compare between projects when making decisions. ^[4]

Discounted Cash Flow (DCF), on the other hand, estimates the value of project by forecasting its future cash flows and discounting them to their present value. ^[5] Attempts to determine the value of an investment today, based on projections of how much money that project will generate in the future. ^[6]

This article is structured explaining three key concepts (Time Value of Money, Discounted Cash Flow and Net Present Value). It also further explains both concepts together with the calculation methods, showing how deeply related they are and their relevance in management. Advantages and disadvantages of these methods are critically analyzed and presented. At the end, the article briefly highlights the key references used.

Time Value of Money

$1 of today is worth more than $1 of tomorrow

Time value of money (TVM) is a core financial principle that states a sum of money is worth more now than it will be in the future. ^[7]. This is because when the investor has the money available, it can be re-inverted generating more profits. Money available at different points in time has different values, which means that a sum of money’s value depends on how long you must wait to use it. The sooner you can use it, the more valuable it is. ^[8]

TVM plays a crucial role for investment analysis, particularly when assessing future cash flows and expected investment returns. Investors rely on this concept to assess businesses’ present values based on projected future returns, which helps them decide which investment opportunities to prioritize and pursue. ^[8] When investment options vary in time horizons, the TVM helps in determining the most profitable choice based on the present and future value of the money invested.

This concept is used becomes highly relevant when explaining and calculating decision parameters like the Discounted Cash Flow (DCF) and Net Present Value (NPV)

Discounted Cash Flow (DCF)

Discounted Cash Flow (DCF) is a valuation method that helps to estimate what an asset is worth today by using expected future cash flows. It is a way of valuing a project or purchase to determine whether its return is worth the investment. A DCF analysis reports how much money can be spent on the investment in the present in order to get a desired return in the future. It can be used to calculate the value of another business, stock, real state, equipment or any long term asset. ^[1] This method operates under the time value of money principle and can be used to determine if in an investment or project is worthwhile comparing it to other alternatives. The mentioned analysis can be applied to value a stock, company, project, and many other assets or activities, and thus is widely used in both the investment industry and corporate finance management.

The purpose of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money and compare it with the initial investment. If the DCF is greater than the present cost, the investment is profitable. The higher the DCF, the greater return the investment generates. If the DCF is lower than the present cost, investors should rather hold the cash. ^[9] This method adjusts the value of the future cash flows to the present value using a discount rate, that is associated with each individual project or investment.

To make a Discounted Cash Flow analysis, the following key elements are needed: ^[1]

• Time frame or periods of time of the investment.
• The investment's projected annual cash flows.
• An interest rate or discount rate.

Discount Rate

In corporate finance, a Discount Rate is the rate of return used to discount future cash flows back to their present value. ^[10] It takes into consideration the time value of money and the risk associated with an investment. In other words, the discount rate is the interest rate used to convert future cash flows into their equivalent value in today’s dollars.

When analyzing investment alternatives, this rate value is often defined as the minimum acceptable rate of return that investors deem acceptable on an investment. The discount rate is determined by assessing the cost of capital, risks involved, opportunities in business expansion, rates of return for similar investments or projects, and other factors that could directly affect an investment or project under consideration. ^[11]

In corporate finance, a single universal rate cannot be applied to all projects or investments. A unique rate has to be defined specially for each individual case. There are different types of Discount Rates that can be calculated depending on the type of investment being analyzed:^[10]

• Weighted Average Cost of Capital (WACC): used for determining the rate at which a company has to pay to access funds.
• Cost of Equity: is the rate of return a company pays out to equity investors.
• Cost of Debt: is the return that a company provides to its debtholders and creditors.
• A pre-defined hurdle rate: minimum rate of return that investors expect to receive on an investment.
• Risk-Free Rate: is the interest rate an investor can expect to earn on an investment that carries zero risk. The risk-free rate is a theoretical number since technically all investments carry some form of risk.

How to calculate DCF

Calculation and example

• Formulas and interpretation

Net Present Value (NPV)

The Net Present Value can be defined as the present value of the investment. It compares future cash flows discounted to its present value, with the initial investment of the project. The result obtained, represents the increase in the wealth of the investor along the time. As previously mentioned, the NPV analysis accounts for the time value of the money and can be used to compare different investment projects being under consideration. ^[12]

In corporate finance, the Net Present Value analysis is one of the tools that investors use when comparing investment projects and deciding which one to pursue. This method provides a concrete number that managers can use to easily compare an initial outlay of cash against the present value of the return. ^[4] The outcome of this method can be either positive or negative. A positive outcome could signify a worthwhile investment, resulting in a profitable return, whereas a negative value would indicate that the project’s return is not enough the make it profitable.

How to calculate NPV

Calculation and example

• Formulas and interpretation

Application of NPV

• Relevance of the method
• Use in decision making when analyzing investment if projects, programs and portfolios

Limitations

• Relevant aspects to keep in mind when using the obtained results

Bibliography

Brealey, R., Myers, S., Allen, F., Principles of Corporate Finance, 10th edition, McGraw-Hill Irwin, 2010 Benninga, S., Financial Modeling, 4th edition, The MIT Press, 2014

References

1. ↑ ^{1.0 1.1 1.2} The Heart Ford: Discounted Cash flow "https://sba.thehartford.com/finance/cash-flow/discounted-cash-flow/"
2. ↑ The Heart Ford: Net Present Value and Discounted Cash Flow "https://sba.thehartford.com/finance/cash-flow/discounted-cash-flow-versus-net-present-value/#:~:text=The%20discounted%20cash%20flow%20analysis,is%20taken%20in%20and%20spent"
3. ↑ Investopedia: Net Present Value "https://www.investopedia.com/terms/n/npv.asp"
4. ↑ ^{4.0 4.1} Harvard Business Review: Net Present Value "https://hbr.org/2014/11/a-refresher-on-net-present-value"
5. ↑ Street of Walls: Discounted Cash Flow Analysis https://www.streetofwalls.com/finance-training-courses/investment-banking-technical-training/discounted-cash-flow-analysis/"
6. ↑ Investopedia: Discounted Cash Flow "https://www.investopedia.com/terms/d/dcf.asp"
7. ↑ Harvard Business School: Finance Principles "https://online.hbs.edu/blog/post/finance-principles"
8. ↑ ^{8.0 8.1} Harvard Business School: Time Value of Money "https://online.hbs.edu/blog/post/time-value-of-money"
9. ↑ Corporate Finance Institute: Discounted Cash Flow "https://corporatefinanceinstitute.com/resources/valuation/discounted-cash-flow-dcf/"
10. ↑ ^{10.0 10.1} Corporate Finance Institute: Discount Rate "https://corporatefinanceinstitute.com/resources/valuation/discount-rate/"
11. ↑ Corporate Finance Institute: Hurdle Rate "https://corporatefinanceinstitute.com/resources/valuation/hurdle-rate-definition/"
12. ↑ Corporate Finance Institute: Net Present Value "https://corporatefinanceinstitute.com/resources/valuation/net-present-value-npv/