Discounted Cash Flow Analysis

Instructor: James Blackburn

James has an MBA from Auburn University and a MA in Humanities from Cal State-Dominguez Hills He writes on leadership, business strategy and finance.

Discounted cash flows are used to evaluate investment opportunities. In this lesson, we will review the Net Present Value and Internal Rate of Return methods in evaluating projects and investments. We will also work through an example.

Business Case for Discounted Cash Flow

The Vice President of Engineering has just completed her presentation on a new robot design. Engineering estimates the costs of development at $10 million. The development time is 24 months and the life of the design is five years. The marketing team believes the new design could revolutionize the home health care industry. The VP of Marketing estimates sales to be worth $25 million per year for the next five years. Accounting estimates a 10% profit on the line for each of the first five years. Should we invest in the new project?

Discounted Cash Flow Analysis Methods

The back of the napkin calculation seems straight forward. The company would recognize a profit of $2.5 million dollars per year or $12.5 million for the time period. The $12.5 million profit more than covers the $10 million in development costs. So, we should choose the robot project.

Is it really that simple? Not quite. Discounted Cash Flow (DCF) is used to evaluate and compare investments and projects. Another project with an estimated 15% return is also under consideration. Which project should we choose? To answer this question, we will use the estimated return of the other project for comparison as our required rate of return on the robot project. We will calculate the Net Present Value of the project. By using this formula, the finance team can calculate the sum of the present value of future cash flows.

PV DCF

Net Present Value (NPV)

Let's start with a simple example. We will use the present value formula with a $1,000 cash flow received each year for 5 years with a 10% required rate of return. Each cash flow is divided by the quantity of one plus the required rate raised to the year of the cash flow. As the years increase, the present value of the cash flow decreases.

PV E1

Now that we have shown an easy example, let's turn our attention to the problem at hand. Don't worry, we will take it in stages. Accounting estimated a profit of $2,500,000 per year for five years. We will begin to receive this profit in year three of the project. For now, we will ignore the cash outflows for development and cash inflows for any sales of the equipment at the end.

PV Sales Robot

Notice that we used periods three through seven to calculate the present value. At first glance, the present value of $6.3 million dollars is less than the $12.5 million we estimated on the napkin. So, you can see the impact the required rate of return has on the value of the project.

Next, we will calculate the cash outflows for development and inflows of cash for manufacturing equipment sales. Let's assume that the $10 million is allocated at $3 million for the first year and $7 million for the second year. After 5 years, the manufacturing equipment used in the creation of the robots is estimated to have a resale value of $5,000,000. How do the cash outflow and the resale of equipment affect the investment decision?

NPV Robot

You may have noticed the first two cash flows are negative. The negative sign symbolizes the outflow of cash. You will also notice we added the $5,000,000 in equipment sales at the end of the product lifecycle to the last cash flow. The net present value of the project is estimated at $315,374. It's above zero and suggests that the project will exceed the required rate of return.

Internal Rate of Return (IRR)

We are deciding between two different projects. Since we used the estimated return of the other project, instead of the cost of capital, the fact that the NPV is greater than zero suggests it has a higher rate of return than the first project. But, what exactly is the rate of return?

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