![]() ![]() The NPV of 14 is how much richer the firm will be after doing this project, compared with not doing it. Internal rate of return (IRR) calculates a ‘return’, in much the same way as ROCE. Net present value (NPV) uses a given discount rate. By way of contrast, a ‘geared analysis’ looks ‘post financing’ and is where cash flows to equity holders only are analysed. Ungeared analysis is used for project appraisal and can also be used to value a whole enterprise. Past cash flows and financing cash flows are excluded. It is a cash flow and not an accounting analysis. The usual analysis is called ‘ungeared’ and includes the free cash flows to the firm, ie profit, depreciation, movements in working capital and taxation. These calculations can be expanded to all manner of cash flows. The treasurer can also calculate the DCF as follows: 100 x e-0.04 x 1, which is 96.08 This version can be manipulated more easily in complicated financial calculations, but does assume that interest is received continuously over the period. We have shown the classic calculation, but a useful alternative to understand is the ‘continuously compounded’ version, which is: P x e-rt, where e=2.71828 (actually a mathematical constant that appears frequently in many growth patterns), r is the interest rate and t is time. The best way to view a discount rate is as an ‘opportunity cost’, so it is what the money would earn if it was not used in this project. In this case, we have used a ‘discount rate’ to make a valuation. ![]() 100 x (1.04)-1, which is 96.15 So, if more than $96.15 were received, it would be worth accepting the lesser amount today. The break even is calculated as follows: P x (1 + r)-t, where P is the principal, r is the interest rate and t is time. We could go on to work out the break even and decide what is the equivalent today of $100 in one year’s time. $95 invested at 4% will result in receiving $98.80, so all things being equal, the treasurer would choose $100 in a year’s time. If $95 were received now, it could be invested at 4% per annum. Example 1: discounted cash flowĪ treasurer can choose to receive $95 today or $100 in one year’s time. It allows a manager to choose between alternative cash flow scenarios (for example, to invest or not), or to decide when two cash flows are equivalent. This is called the ‘time value of money’. The crux of DCF is that money received today is worth more than the same money received in the future. For company valuation, multiples are also a very common technique and can complement DCF techniques. For investment appraisal, other common techniques include payback and return on capital employed (ROCE). There are many pretenders to the throne of DCF. ![]() It can be used to value individual cash flows, project cash flows and financial instruments, as well as whole companies. It is, therefore, an investment appraisal technique for individual projects as well as a valuation technique. Business is about investing in projects for a future return and DCF is the purest technique to assess those future returns from any project. Evaluation lies at the heart of all business and especially at the heart of treasury. Will Spinney explainsĭiscounted cash flow (DCF) is an evaluation tool. Discounted cash flow is a powerful tool that can help treasurers make accurate valuations. ![]()
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