Published On:Thursday, 22 December 2011
Posted by Muhammad Atif Saeed
Investment Appraisal tools:
a) Discounted Cash flow tools (Considered Time value of money.)
b) Non-Discounted Cash flow tools (Not considered the time value of money.)
Definition of 'Discounted Cash Flow - DCF'
A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.
Calculated as:
Calculated as:
Discounted Cash Flow Tools:
a) Net Present Value
b) IRR (Internal Rate of Return)
Non Discounted Cash Flow:
A non-discount method of capital budgeting does not explicitly consider the time value of money. In other words, each dollar earned in the future is assumed to have the same value as each dollar that was invested many years earlier. The payback method is one of the techniques used in capital budgeting that does not consider the time value of money.
Non-Discounted Cash Flow Tools:
a) Pay Back
b) ARR (Accounting Rate of Return
Time Value of Money:
Definition: Amount which you received is more valuable than the amount received in future.
DCF is a project appraisal technique that is based on the concept of the time value of money that Rs 1 earned or spent sooner is worth more than Rs. 1 earned or spent later. Various reasons could be suggested as to why a present Rs. 1 is worth more than a future Rs. 1.
Uncertainty. The business world is full of risk and uncertainty, and although there might be the promise of money to come in the future, it can never be certain that the money will be received until it has actually been paid. This is an important argument, and risk and uncertainty must always be considered in investment appraisal. But this argument does not explain why the discounted cash flow technique should be used to reflect the time value of money.
Inflation. Because of inflation it is common sense that £1 now is worth more than £1 in the future. It is important, however, that the problem of inflation should not confuse the meaning of DCF, and the following points should be noted.
– If there were no inflation at all, discounted cash flow techniques would still be used for investment appraisal.
– Inflation, for the moment, has been completely ignored.
– It is obviously necessary to allow for inflation.
An individual attaches more weight to current pleasures than to future ones, and would rather have £1 to spend now than £1 in a year's time. Individuals have the choice of consuming or investing their wealth and so the return from projects must be sufficient to persuade individuals to prefer to invest now. Discounting is a measure of this time preference.
Money is invested now to make profits (more money or wealth) in the future. Discounted cash flow techniques can therefore be used to measure either of two things.
– What alternative uses of the money would earn (NPV method) (assuming that money can be invested elsewhere at the cost of capital)
– What the money is expected to earn (IRR method – to be covered in the next section of this chapter)
