Finance

Discounted Cash Flow

Discounted Cash flow is an approach aimed at evaluating the financial aspects of a project , a company or its assets , and it uses the concepts of Time Value of Money . All future cash flows are discounted and estimated to their present values . The discounting methodology is employed in determining the economic attractiveness of capital investment projects , which reduces the value of future cash receipts or payments

Net Present Value (NPV

The net present value , in simple words , can be described as the present value of cash flows

minus the investments . The NPV of an investment in a particular project is the present value of expected cash inflows less the present value of the project 's expected cash outflows , discounted at the appropriate cost of capital

The following procedure is used to compute the NPV of a project , as described by Brealey , Myers and Marcus (2001

Identifying all the costs (outflows ) and benefits (inflows ) that are associated with an investment

Determining the appropriate discount rate or opportunity cost for the investment

Using the appropriate discount rate to find the present value of each cash flow

Computing the NPV , as the sum of all the DCF

Mathematically , it may be expressed as where

Ct the expected net cash flow at time t

Co the initial cash outlay

T the estimated life of the investment

r the discount rate or the opportunity cost of capital

The basic idea behind NPV analysis is that if a project has a positive NPV , this amount goes to the firm 's shareholders . As such , if a firm undertakes a project with a positive NPV , shareholder wealth is increased

The NPV decision rules , as described by Brealey , Myers and Marcus (2001 , may be summarized as follows

Accept projects with a positive NPV . Positive NPV projects will increase shareholder wealth

Reject with a negative NPV . Negative NPV projects will decrease shareholder wealth

When two projects are mutually exclusive , the project with the higher positive NPV should be accepted

Internal Rate of Return (IRR , Yield

IRR is defined as the rate of return that equates the Present value of an investment 's expected benefits (inflows ) with the present value of its costs (outflows , as expressed by Mathur (2002 . Equivalently , the internal rate of return may be defined as the discount rate for which the NPV of an investment is zero

Calculating IRR requires only that we identify the relevant cash flows for the investment opportunity being evaluated . Market-determined discount rates , or any other external (market-driven ) data , are not necessary with the IRR procedure . The general formula for the IRR is Source : Keown (2004 .

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Analyzing an investment (project ) using the IRR method provides the analyst with a are result in terms of a rate of return . The following are the decision rules of IRR analysis , as discussed by Helfert (2001

Accept projects with an IRR that is greater than the firm 's (investors required rate of return

Reject projects with an IRR that is less than...