Discounted Cash Flows

The methods of investment appraisal which we have just examined are generally regarded as producing misleading results. Discounted cash flow has gained widespread acceptance for it recognizes that the value of money is subject to a time-preference, that is, that £1 today is preferred to £1 in the future unless the delay in receiving £1 in the future is compensated by an interest factor. This interest factor is expressed as a discount rate.

In simple terms, the DCF method attempts to evaluate an investment proposal by comparing the net cash flows accruing over the life of the investment at their present-day value with the value of funds presently to be invested. Thus, by comparing like with like it is possible to calculate the rate of return on the investment in a realistic manner.

To find the present equivalent value of £1 receivable one year hence, one applies the rate of interest to discount that £1 to its present day value. This is the same thing as asking 'what sum of money invested today at the rate of interest would increase in value to £1 a year hence?'

Example

Given that the rate of interest is 10 per cent per annum the following calculations may be made:

£1 invested now at 10 per cent will amount to £1.10 in a year. Conversely, the value of £1.10 a year's hence is worth £1 now if the rate of interest is 10 per cent.

Using this principle, discount tables may be constructed for the value of £1 over several time periods ahead by compounding the interest rate through time, i.e., £1.00 invested for 1 year at 10 per cent will be worth £1.10 at the year end, £1.10 then reinvested for another year at 10 percent will be worth £1.10 + 0.11 = £1.21 at the end of the second year.

The value of money is, therefore, directly affected by time and the rate of interest is the method which is used to express the time value of money. Compound interest tables and discount tables are available which show the value of money at different interest rates over a number of years, so that in actual practice, it is a simple matter to apply the DCF method to the evaluation of an investment.


Interested in Subsidiaries

Read on: The Relevant Cash Flows

Before we proceed to examining the methods of selecting investment projects, let us briefly define the meaning of the terms which we shall be employing.

(a) Net investment outlays

These consist of initial investment outlays required to establish the project, and the subsequent investment outlays which are envisaged at the outset, and are distinguishable from operating cash outlays. Thus, initial investment outlays may comprise expenditure on equipment, installation costs, manpower training, working capital etc. Subsequent investment outlays may include 'second stage' developments,... see: The Relevant Cash Flows