discounted cash flows

Examples of discounted cash flows in the following topics:

• Discounted Cash Flow Approach

  • A discounted cash flow analysis is a highly useful tool for calculating the net present value of a given product, process, asset, or organization.
  • NPV analyses using the discounted cash flow approach are widely used across various industries to decide which projects to invest in.
  • The discounted cash flow formula focuses on determining the relative time value of money of each projected cash flow (i.e. monthly, quarterly, annually, etc.), bringing each forecast of future value into present value terms.
  • The inputs for a discounted cash flow analysis are:
  • This is a good example of a what a discounted cash flow analysis would look like on paper, particularly as a prospective investor.

• NPV Profiles

  • The NPV calculation involves discounting all cash flows to the present based on an assumed discount rate.
  • Thus, when discount rates are large, cash flows further in the future affect NPV less than when the rates are small.
  • Conversely, a low discount rate means that NPV is affected more by the cash flows that occur further in the future.
  • The NPV Profile assumes that all cash flows are discounted at the same rate.
  • A higher discount rate places more emphasis on earlier cash flows, which are generally the outflows.

• Present Value of Payments

  • The value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate.
  • As with any security or capital investment, the theoretical fair value of a bond is the present value of the stream of cash flows it is expected to generate.
  • Therefore, the value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate.
  • In practice, this discount rate is often determined by reference to similar instruments, provided that such instruments exist.
  • The formula for calculating a bond's price uses the basic present value (PV) formula for a given discount rate .

• Cash Flow

  • Cash flow is the movement of money into or out of a business.
  • Cash flow is extremely important to a firm.
  • One way to get cash flow quickly is through seasonal discounts .
  • Another option is cash discounts.
  • A quick way to generate cash flow is to offer seasonal discounts.

• Cash Flow from Financing

  • One of the three main components of the cash flow statement is cash flow from financing.
  • Receiving the money is a positive cash flow because cash is flowing into the company, while each individual payment is a negative cash flow.
  • Extending credit is an investing activity, so all cash flows related to that loan fall under cash flows from investing activities, not financing activities.
  • For example, a company may issue a discount which is a financing expense.
  • However, because no cash changes hands, the discount does not appear on the cash flow statement.

• Defining NPV

  • In order to see whether the cash outflows are less than the cash inflows (i.e., the investment earns a positive return), the investor aggregates the cash flows.
  • Since cash flows occur over a period of time, the investor knows that due to the time value of money, each cash flow has a certain value today .
  • Thus, in order to sum the cash inflows and outflows, each cash flow must be discounted to a common point in time.
  • Also recall that PV is found by the formula $PV=\frac { FV }{ { (1+i) }^{ t } }$ where FV is the future value (size of each cash flow), i is the discount rate, and t is the number of periods between the present and future.
  • The PV of multiple cash flows is simply the sum of the PVs for each cash flow.

• Cash flow forecasts

  • This is why cash flow forecasts are prepared.
  • Cash flow forecasts are often prepared for longer periods of time as well, depending on circumstances.
  • Unlike the income statement, a cash flow statement deals only with actual cash transactions.
  • Depreciation, a non-cash transaction, does not appear on a cash flow statement.
  • Loan payments (both principal and interest) will appear on your cash flow statement since they require the outlay of cash.

• Calculating the Payback Period

  • Start by calculating Net Cash Flow for each year: Net Cash Flow Year 1 = Cash Inflow Year 1 - Cash Outflow Year 1.
  • Then Cumulative Cash Flow = (Net Cash Flow Year 1 + Net Cash Flow Year 2 + Net Cash Flow Year 3 ... etc.)
  • Some businesses modified this method by adding the time value of money to get the discounted payback period.
  • They discount the cash inflows of the project by a chosen discount rate (cost of capital), and then follow usual steps of calculating the payback period.
  • Then the cumulative positive cash flows are determined for each period.

• Calculating the NPV

  • The NPV is found by summing the present values of each individual cash flow.
  • Cash inflows (such as coupon payments or the repayment of principal on a bond) have a positive sign while cash outflows (such as the money used to purchase the investment) have a negative sign.
  • The accurate calculation of NPV relies on knowing the amount of each cash flow and when each will occur.
  • Since many people believe that it is appropriate to use higher discount rates to adjust for risk or other factors, they may choose to use a variable discount rate.
  • NPV is the sum of of the present values of all cash flows associated with a project.

• Preparation of the Statement of Cash Flows: Direct Method

  • There is an indirect and a direct method for calculating cash flows from operating activities.
  • The following is an example of using the direct method for calculating cash flows.
  • For example, if the interest expense is ten dollars, and the unamortized discount decreases by three dollars, then the cash paid for interest is seven dollars.
  • Cash flows refer to inflows and outflows of cash from activities reported on an income statement.
  • Explain the direct method for preparing the statement of cash flows