discounted cash flow

Examples of discounted cash flow in the following topics:

• Discounted Cash Flow Approach

  • The discounted cash flow approach finds the value of an asset using its expected return and the present values of future cash flows.
  • The discounted cash flow (DCF) approach utilizes the time value of money concept to find the value of an asset.
  • -- FCFN+1 = future cash flow one year after the projection period. k = discount rate. g = assumed constant growth rate.
  • FCFN+1 = future cash flow one year after the projection period. k = discount rate. g = assumed constant growth rate.
  • Calculate the value of a project using the discounted cash flow approach

• Discounted Payback

  • Discounted payback period is the amount of time to cover the cost, by adding positive discounted cash flow coming from the profits of the project.
  • Assuming the discount rate is 10%, we would apply the following formula to each cash flow.
  • Discounted Cash Flow at 10%: Year 0: -2000, year 1: 909, year 2: 827, year 3: 1503.
  • The next step is to compute the cumulative discounted cash flow, by summing the discounted cash flow for each year.
  • Accumulated discounted cash flows: Year 0: -2000, year 1: -1091, year 2: -264, year 3: 1239.

• NPV Profiles

  • The NPV calculation involves discounting all cash flows to the present based on an assumed discount rate.
  • Thus, when discount rates are large, cash flows further in the future affect NPV less than when the rates are small.
  • Conversely, a low discount rate means that NPV is affected more by the cash flows that occur further in the future.
  • The NPV Profile assumes that all cash flows are discounted at the same rate.
  • A higher discount rate places more emphasis on earlier cash flows, which are generally the outflows.

• Cash Flow

  • Cash flow is the movement of money into or out of a business.
  • Cash flow is extremely important to a firm.
  • One way to get cash flow quickly is through seasonal discounts .
  • Another option is cash discounts.
  • A quick way to generate cash flow is to offer seasonal discounts.

• Cash Flow from Financing

  • One of the three main components of the cash flow statement is cash flow from financing.
  • Receiving the money is a positive cash flow because cash is flowing into the company, while each individual payment is a negative cash flow.
  • Extending credit is an investing activity, so all cash flows related to that loan fall under cash flows from investing activities, not financing activities.
  • For example, a company may issue a discount which is a financing expense.
  • However, because no cash changes hands, the discount does not appear on the cash flow statement.

• Defining NPV

  • In order to see whether the cash outflows are less than the cash inflows (i.e., the investment earns a positive return), the investor aggregates the cash flows.
  • Since cash flows occur over a period of time, the investor knows that due to the time value of money, each cash flow has a certain value today .
  • Thus, in order to sum the cash inflows and outflows, each cash flow must be discounted to a common point in time.
  • Also recall that PV is found by the formula $PV=\frac { FV }{ { (1+i) }^{ t } }$ where FV is the future value (size of each cash flow), i is the discount rate, and t is the number of periods between the present and future.
  • The PV of multiple cash flows is simply the sum of the PVs for each cash flow.

• Cash flow forecasts

  • This is why cash flow forecasts are prepared.
  • Cash flow forecasts are often prepared for longer periods of time as well, depending on circumstances.
  • Unlike the income statement, a cash flow statement deals only with actual cash transactions.
  • Depreciation, a non-cash transaction, does not appear on a cash flow statement.
  • Loan payments (both principal and interest) will appear on your cash flow statement since they require the outlay of cash.

• Calculating the Payback Period

  • Start by calculating Net Cash Flow for each year: Net Cash Flow Year 1 = Cash Inflow Year 1 - Cash Outflow Year 1.
  • Then Cumulative Cash Flow = (Net Cash Flow Year 1 + Net Cash Flow Year 2 + Net Cash Flow Year 3 ... etc.)
  • Some businesses modified this method by adding the time value of money to get the discounted payback period.
  • They discount the cash inflows of the project by a chosen discount rate (cost of capital), and then follow usual steps of calculating the payback period.
  • Then the cumulative positive cash flows are determined for each period.

• Calculating the NPV

  • The NPV is found by summing the present values of each individual cash flow.
  • Cash inflows (such as coupon payments or the repayment of principal on a bond) have a positive sign while cash outflows (such as the money used to purchase the investment) have a negative sign.
  • The accurate calculation of NPV relies on knowing the amount of each cash flow and when each will occur.
  • Since many people believe that it is appropriate to use higher discount rates to adjust for risk or other factors, they may choose to use a variable discount rate.
  • NPV is the sum of of the present values of all cash flows associated with a project.

• Preparation of the Statement of Cash Flows: Direct Method

  • There is an indirect and a direct method for calculating cash flows from operating activities.
  • The following is an example of using the direct method for calculating cash flows.
  • For example, if the interest expense is ten dollars, and the unamortized discount decreases by three dollars, then the cash paid for interest is seven dollars.
  • Cash flows refer to inflows and outflows of cash from activities reported on an income statement.
  • Explain the direct method for preparing the statement of cash flows