discounted cash flow technique
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Discounted Cash Flow TechniqueTRANSCRIPT
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Investment appraisal Discounted cash flow (DCF) technique
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DCF considers what we will refer to as the TIME VALUE OF MONEY.
The time value of money describes the concept that the earlier cash is received, the greater value it has to the recipient. Conversely, the later a cash payment is made, the less the cost to the payer.
1,000 today is worth more than say the same 1,000 in a years time
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The idea of the time value of money is further explored using Present Value (PV) and Future Value (FV)
PV = Present Value
FV = Future Value
r = Rate of interest or cost of capital
n = Number of periods (years)
FV = PV (1 + r) n
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Year 0 (Now) Year 1 Year 2 Year 3 Year 4 Year 5 PV FV FV FV FV FV Given Present Values (PV) to obtain the Future Values (FV) we compound and the process is called compounding
Given Future Values (FV) to obtain the Present Values (PV) we discount and the process is called discounting
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Example: Warmah ltd has invested 50,000 in a fixed deposit for a period of five years. The current interest rate offered on such fixed deposit is 6% p.a.
How much will be received by Warmah ltd in four years time.
Answer 4
FV = 50,000 (1 +0.06) = 63,123.85
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Example: WBS plc require $400,000 in eight years time, to undertake an investment in new equipments for production. How much should it invest now in a fixed deposit, if the rate of interest is 12% p.a.
Solution:
PV = 400,000 / (1.12)8 = 161,553.29
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When candidates are given cost of capital of say 10% and wish to find the discount factor for each of the years from year 1 to 5 without using the discount (or present value) table:
The formula to obtain the discount factor for each year is as follows:
DF = 1 / (1 +r)n
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DF = 1 / (1 +r)n
Year 1 = 1 / (1 +0.1)1 = 0.909
Year 2 = 1 / (1 +0.1)2 = 0.826
Year 3 = 1 / (1 +0.1)3 = 0.751
Year 4 = 1 / (1 + 0.1)4 = 0.683
Year 5 = 1 / (1 + 0.1)5 = 0.621
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