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Discounted cash flow techniques based on the time value of money - Coggle…
Discounted cash flow techniques based on the time value of money
The use of discounted cash flows (DCF) Is important for investment appraisal
DCF models take into account the timing of cash flows over a project's life
Look at cash flows of a project, not accounting profits because cash flows show the costs and benefits of the project when they actually occur and ignore notional costs such as depreciation
Time value of money
The time value of money is the concept that money received today is worth more than the same sum receive in the future because of
Potential for earning interest and savings on the cost of finance
If money is received today it can either be spent or reinvested to earn more in future
Investors have a preference for having cash/liquidity today
Savings now can also be used to repay debts, saving on cost of finance
Impact of inflation
The value of future cash flows can be eroded by inflation
Effect of risk
Future cash receipts may be uncertain unlike cash received today
Compounding
Money invested today will earn interest in future
Compounding calculated the future value of a given sum invested today for a number of years
FV = PV (1+ r)n
Where
FV = future value
PV = present value
r = rate of compound interest
N = number of years
Discounting
The timing of cash flows is taken into account by discounting
This is the opposite of compounding - it starts with a future value to reach a present value
This provides a discounted value of a future sum of money or stream of cash flows using a specified rate of return
Present value means a current cash equivalent of a discounted sum of money receivable or payable at a future date
A discount rate is the rate of return used in discounted cash flow anaysis to determine the present value of future cash flows
The discount rate will give the current worth of the future value
PV - FV / (1+r)n
The present value factor is 1 / (1+r)n