Investment appraisal Discounted cash flow

(DCF) technique
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DCF considers what we will refer to as the
TIME VALUE OF MONEY.
The time value of money describes the
concept that the earlier cash is received, the
greater value it has to the recipient.
Conversely, the later a cash payment is made,
the less the cost to the payer.
1,000 today is worth more than say the
same 1,000 in a years time
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The idea of the time value of money is further
explored using Present Value (PV) and Future
Value (FV)
PV = Present Value
FV = Future Value
r = Rate of interest or cost of capital
n = Number of periods (years)


FV = PV (1 + r)
n


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Year 0 (Now) Year 1 Year 2 Year 3 Year 4 Year 5

PV FV FV FV FV FV




Given Present Values (PV) to obtain the Future Values (FV) we compound and the process
is called compounding




Given Future Values (FV) to obtain the Present Values (PV) we discount and the
process is called discounting



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Example: Warmah ltd has invested 50,000 in
a fixed deposit for a period of five years. The
current interest rate offered on such fixed
deposit is 6% p.a.
How much will be received by Warmah ltd in
four years time.
Answer 4
FV = 50,000 (1 +0.06) = 63,123.85
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Example: WBS plc require $400,000 in eight
years time, to undertake an investment in
new equipments for production. How much
should it invest now in a fixed deposit, if the
rate of interest is 12% p.a.
Solution:
PV = 400,000 / (1.12)
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= 161,553.29
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When candidates are given cost of capital of
say 10% and wish to find the discount factor
for each of the years from year 1 to 5 without
using the discount (or present value) table:
The formula to obtain the discount factor for
each year is as follows:
DF = 1 / (1 +r)
n
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DF = 1 / (1 +r)
n
Year 1 = 1 / (1 +0.1)
1
= 0.909
Year 2 = 1 / (1 +0.1)
2
= 0.826
Year 3 = 1 / (1 +0.1)
3
= 0.751
Year 4 = 1 / (1 + 0.1)
4
= 0.683
Year 5 = 1 / (1 + 0.1)
5
= 0.621
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