Net Present Value (NPV) - Discounted cash flow

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. 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.

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. 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.

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. Attempts to determine the value of an investment today, based on projections of how much money that project will generate in the future.

These two concepts work together when analyzing a project or portfolio investment. The discounted cash flow analysis considers a discount rate to find the present value of the projected cash flows of the project. Further in the analysis, the net present value subtracts the discounted cash flow value from the initial cost of investment. A decision can be made based on the result of the net present value. If it is positive, then it may be a good investment since it would provide a return. If the value is negative, means that the project could not generate enough return for the investment.

This article further explains both concepts, showing how deeply related they are and their relevance in management. It also critically reflects on their advantages and disadvantages of these methods and briefly highlights the key references used.