It is advisable for an organization to make the right investments to ensure a steady cash flow. If you are putting your money in the right investment vehicles, it would provide you with much-needed financial cushioning in the future. However, it is important to assess which investments will have the maximum impact on your future cash flow with the help of discounted cash flow.
Discounted cash flow is a popular valuation method that involves estimating the value of an investment based on its tentative future cash flows. In other words, it allows you to ascertain how fruitful investment is based on the likelihood of impacting your cash flow in a positive way. In essence, discounted cash flow analysis involves assessing the current value of an investment on the basis of the returns it will generate in the future.
Discounted cash flow techniques are used for assessing a range of different business investments, such as buying stocks, acquiring companies, and making other important decisions regarding operating expenditures.
Here, we will discuss the three major discounted cash flow techniques – Net Present Value (NPV), Internal Rate Of Return (IRR), and Profitability Index (PI).
Net Present Value (NPV)
The Net Present Value (NPV) is one of the most common and classic ways of evaluating an investment. It gives importance to the time value of money, i.e., the increment in the value of money with time. The technique revolves around the postulation that cash flows belonging to different time periods possess different values and can be compared only if their present values (equivalents) are taken into consideration.
The Net Present Value (NPV) is essentially the difference between the current value of the cash inflows of a project (investment) and the original cost of the concerned project.
Here are the three steps involved in calculating the NPV of an investment:
- Select an ideal rate of interest for discounting the cash flows. This will be considered the “cost of capital” for your company.
- Now, you need to go ahead with computing the present value of cash inflows and outflows of the concerned investment by discounting them with the cost of capital.
- You will get the Net Present Value (NPV) by deducting the present value of cash outflows from the present value of cash inflows.
If you get a positive NPV after doing all the calculations, you can consider the investment to be fruitful and worth putting your money in. On the other hand, a negative NPV should dissuade you from investing your money in the concerned project. If you have multiple investment projects at your disposal, the one with the highest NPV would be considered to be the best.
Here are some of the major benefits of using the NPV technique of discounted cash flow:
- It takes the complete cash flows generated during the life of an investment into consideration
- It makes use of the time value of money for accurate assessments
- It is in sync with the objective of maximizing the wealth of the investors
- The ranking of multiple investments is independent of the discount rate used to determine the present value of an investment.
Internal Rate Of Return (IRR)
Initially advocated by Joel Dean, this discounted cash flow technique takes the timing and magnitude of cash flows into consideration while making assessments. The Initial Rate of Return (IRR) refers to the rate used for equating the current value of your cash inflows with the current value of cash outflows pertaining to a specific investment. Essentially, it is the rate at which the NPV of an investment is zero.
If the IRR of an investment is more than the cost of capital, you will earn more than the funds you invested in the concerned asset. If the IRR of an investment is equal to the cost of capital, you should be indifferent to the investment as it does not make you any profit or loss.
The formula for IRR can be computed as follows:
Internal Rate of Return (IRR) = L + [(P1 – C) x D (P1 – P2) x 100]
L = Lower rate of interest,
P1 = The present value at a lower rate of interest,
P2 = The present value at a higher rate of interest,
C = Capital investment, and
D = The difference in the rate of interest
The IRR is determined by trial and error. Here are the steps involved in computing IRR:
- Start by calculating the current value of the cash flows from the given investment with the help of an arbitrary-selected interest rate.
- Now, compare the same with the current value obtained with capital outlay.
- If the current value is more than the cost, you will need to determine the present value of inflows using a higher rate.
- Continue this process until the current value of inflows from the concerned investment is more or less equal to its outflow.
- The interest rate that makes the two elements equal is your IRR.
Probability Index (PI)
Also known as the cost-benefit ratio, the Probability Index (PI) method is another popular discounted cash flow technique used by organizations around the world. This method can be arrived at by making a small change in the NPV technique.
Here, the current value of cash outflows is divided by the current value of cash inflows. This would give you the Probability Index (PI) which is a relative measure as compared to NPV which was an absolute measure. If the PI of investment is more than 1, it is considered to be a fruitful investment. This technique is used more often as compared to NPV as it is used in projects having different cash outlays.
The Final Word
These were the three most important discounted cash inflow techniques used for assessing the efficiency of an investment. Make sure you use the right technique for evaluating the right investment made by your business by taking the help of finance and wealth management experts.