Discounted Cash Flow Methods – A Level Business CAIE Revision

Understanding Discounted Cash Flow Methods

Discounted Cash Flow (DCF) methods are techniques used in investment appraisal that take into account the time value of money.
It recognises that a pound received in the future is worth less than a pound today. This is due to factors like inflation, risk, and opportunity cost.
DCF techniques help to evaluate the attractiveness of an investment by estimating the return on it and adjusting future cash inflows and outflows to present value terms.
This provides a more accurate picture of an investment’s profitability as it takes into account the diminishing value of future earnings.

Two primary types of DCF methods used in investment appraisal are Net Present Value (NPV) and Internal Rate of Return (IRR).
NPV involves calculating the present value of all cash inflows and outflows associated with the investment. The net difference between these is the investment’s NPV.
An investment is considered attractive if it has a positive NPV, meaning that the present value of cash inflows exceeds the present value of cash outflows.
IRR on the other hand, is the discount rate at which the NPV of an investment equals zero.
It provides an indicator of the profitability of an investment in percentage terms, thereby enabling comparisons with other investments or rates of interest.

The calculation of discounted cash flows involves estimating the cash inflows and cash outflows over the life of the investment and then discounting these to their present value using a discount rate.
The discount rate typically reflects the riskiness of the investment. A riskier investment will usually have a higher discount rate.
The formula for calculating present value is: Present Value = Future Value / ((1 + i) ^ n), where ‘i’ is the discount rate and ‘n’ is the number of periods (e.g., years).
This calculation is repeated for each time period in which cash flow is expected. The sum of all the discounted cash flows is the net present value of the investment.

DCF methods are considered more accurate measures of investment appraisal compared to non-discounted methods like payback period or accounting rate of return.
However, they are more complex and require decisions on factors like the appropriate discount rate, the estimation of future cash flows and the investment’s lifespan.
Despite their complexity, DCF methods provide meaningful insights into an investment’s potential profitability and risk profile, making them quite valuable in the investment decision-making process.