Net Present Value (NPV) - Discounted cash flow
Contents |
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]. Money available at different points in time has different values. 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.
Discounted Cash Flow (DCF)
Discounted Cash Flow (DCF) is a method that helps estimate what an asset is worth today by using projected cash flows. It reports how much money can be spent on the investment in the present in order to get a desired return in the future. [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 purpose of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money. [3] 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.
Discount Rate
Concept, definition and relevance
How to calculate DCF
Calculation and example
Net Present Value (NPV)
Definition and relevance
How to calculate NPV
Calculation and example
Discussion
Advantages
Disadvantages
References
- ↑ 1.0 1.1 The Heart Ford: Discounted Cash flow "https://sba.thehartford.com/finance/cash-flow/discounted-cash-flow/"
- ↑ 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"
- ↑ 3.0 3.1 Investopedia: Net Present Value "https://www.investopedia.com/terms/n/npv.asp"
- ↑ Harvard Business Review: Net Present Value "https://hbr.org/2014/11/a-refresher-on-net-present-value"
- ↑ Street of Walls: Discounted Cash Flow Analysis https://www.streetofwalls.com/finance-training-courses/investment-banking-technical-training/discounted-cash-flow-analysis/"
- ↑ Investopedia: Discounted Cash Flow "https://www.investopedia.com/terms/d/dcf.asp"
- ↑ Harvard Business School: Finance Principles "https://online.hbs.edu/blog/post/finance-principles"
- ↑ 8.0 8.1 Harvard Business School: Time Value of Money "https://online.hbs.edu/blog/post/time-value-of-money"
