All Summaries | Business Book Summaries. Discounted cash flow. In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs)—the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question. Present value may also be expressed as a number of years' purchase of the future undiscounted annual cash flows expected to arise. Discounted cash flow analysis is widely used in investment finance, real estate development, corporate financial management and patent valuation. Discount rate[edit] The most widely used method of discounting is exponential discounting, which values future cash flows as "how much money would have to be invested currently, at a given rate of return, to yield the cash flow in future.
" History[edit] Mathematics[edit] Discounted cash flows[edit] where Continuous cash flows[edit] Discounted payback period. Net present value. In finance, the net present value (NPV) or net present worth (NPW)[1] of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values (PVs) of the individual cash flows of the same entity. In the case when all future cash flows are incoming (such as coupons and principal of a bond) and the only outflow of cash is the purchase price, the NPV is simply the PV of future cash flows minus the purchase price (which is its own PV). NPV is a central tool in discounted cash flow (DCF) analysis and is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting and widely used throughout economics, finance, and accounting, it measures the excess or shortfall of cash flows, in present value terms, above the cost of funds.
NPV can be described as the “difference amount” between the sums of discounted: cash inflows and cash outflows. Formula[edit] where – the time of the cash flow ) where is given by: Example[edit] Internal rate of return. Definition[edit] The internal rate of return on an investment or project is the "annualized effective compounded return rate" or "rate of return" that makes the net present value (NPV as NET*1/(1+IRR)^year) of all cash flows (both positive and negative) from a particular investment equal to zero. It can also be defined as the discount rate at which the present value of all future cash flow is equal to the initial investment or in other words the rate at which an investment breaks even.
In more specific terms, the IRR of an investment is the discount rate at which the net present value of costs (negative cash flows) of the investment equals the net present value of the benefits (positive cash flows) of the investment. IRR calculations are commonly used to evaluate the desirability of investments or projects. The higher a project's IRR, the more desirable it is to undertake the project. Uses of IRR[edit] Calculation[edit] Given the (period, cash flow) pairs ( ) where , and the net present value.