DISCOUNTED CASH-FLOW ANALYSIS
Understanding the time value of money
We all know that cars depreciate in value from the moment we drive away from the sales forecourt, and that the money cannot be spent on anything else. Essentially, discounted cash flow is no different. Money has a value – one that changes through time. Inflation means that cash today is worth more than cash tomorrow. That is where discounted cash flow comes in: it is a means of tracking true worth and guiding business and investment decisions.
Overview
When deciding where to invest, you need to take three things into account.
1. Is the risk worth the investment?
2. Are there other projects that would be more lucrative? That is, what is the opportunity cost of using the money in this way rather than on something else?
3. Will the return, over the estimated timescale, outdo inflation? In other words, would you have been better off investing your money elsewhere?
As a starting point, look at the current inflation rate, historical inflation rates, and possible future rates for the markets you are operating in. For example, if inflation is running at 2 per cent (and this is indicative of the historic trend and is unlikely to be eroded by future changes), you will know that, if you invest a certain sum over a certain period, you will need to obtain a return of at least the original sum plus this inflation figure — otherwise, you would have been better off spending your money elsewhere.
The five steps of discounted cash-flow analysis
These five steps will help you to determine the level of investment a project can justify.
1. Identify exactly how the investment will be used — including the timing of all costs and likely sales.
2. Determine both the positive and negative cash flows over time.
3. Estimate the cash flow for when the project has been fully implemented and is likely, given unchanging markets, to continue.
4. Apply the discounted cash-flow figure. This will reveal whether the original investment is worth making. This involves considering how much risk is involved, the cost of any loans, and inflation. This is not an exact science, so it is useful to create best-, medium- and worst-case scenarios. You will also need to consider the expectations of investors.
5. Finally, compare your discounted cash flow with each year of operations. Decide whether the returns justify the investment.
Importantly, profit is not simply a case of deducting costs from sales: it is about knowing the opportunity cost of your money.