Discounted cash flow
Discounted cash flow analysis recognises that the timing of cash flows is important, as well as their amounts.
- Earlier receipts are better than later ones.
- Later payments are better, compared with earlier payments.
- Later receipts are worse.
- Earlier payments are worse.
Discounted cash flow discounts cash flows that are expected at different times in the future, to make them comparable in value with each other and with cash flows received today.
The DCF process is widely used in investment appraisal, where the rate used to discount with is a measure of the appropriately risk-adjusted cost of capital.
Where the sum of discounted future positive cash flows (inflows) is calculated, this is often referred to as the total Present value of those cash flows.
Where the present value of future expected cash flows is netted against discounted investment outflows, this is referred to as the Net present value of the investment proposal.
Discounted cash flow techniques include Net Present Value (NPV) analysis and Internal Rate of Return (IRR) analysis.
When the net present value of proposal is positive, it will normally be considered for further evaluation.
A negative net present value normally indicates that the proposal should be rejected.
When the internal rate of return of proposal is greater than a hurdle (minimum target) rate, it will normally be considered for further evaluation.
An internal rate of return below the hurdle rate normally indicates that the proposal should be rejected.
- Cash balance
- Cash flow
- Cost of capital
- Discount factor
- Discount rate
- Dividend growth model
- Growing perpetuity factor
- Hurdle rate
- Incremental cash flows
- Internal rate of return
- Investment appraisal
- Net present value
- Perpetuity factor
- Present value
- Project appraisal
- Time value of money
Masterclass: Discounted cash flow, Will Spinney, The Treasurer