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.

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. . 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.

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. 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. 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. 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. 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.

Discount Rate

In corporate finance, a Discount Rate is the rate of return used to discount future cash flows back to their present value. 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.

This rate value is often defined as the minimum acceptable rate of return that investors are expecting to receive on an investment. This 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.

How to calculate DCF

Calculation and example

Net Present Value (NPV)

Definition and relevance

How to calculate NPV

Calculation and example