Discounted cash flow

The figures used in Table 5.2 are straightforward and take no account of the time value of money. Money received in the future is worth less than money received today, which can be invested. If the interest rate is 6%, $1 today will be worth $1.06 in a year's time. To put it another way, getting $1 in a year's time is like getting $0.94 today. In other words, the value of the future return on a project must be discounted in the cost/benefit analysis. This approach to forecasting more realistic monetary values is called discounted cash flow.

Table 5.3 adds more detail so the discounted cash flow can be calculated.

Table 5.3 Discounted cash flow ($)

Year 0

Year 1

Year 2

Year 3

Year 4

Benefits

-

13,000.00

70,000.00

71,000.00

81,000.00

Costs

2,500.00

15,850.00

64,620.00

27,400.00

24,250.00

Net

-2,500.00

-2,850.00

5,380.00

43,600.00

56,700.00

Cumulative

-2,500.00

-5,350.00

30.00

43,630.00

100,380.00

Discount factor

1.00

0.94

0.89

0.84

0.79

Discounted net

-2,500.00

-2,688.68

4,788.18

36,607.40

44,951.32

Net present value

-2,500.00

-5,188.68

-400.50

36,206.90

81,158.22

Note: Figures have been rounded.

The first four rows are identical to those used in the straightforward calculation in Table 5.2. The new rows allow the net figure to be discounted by a number of percentage points. The discount factor is the amount by which the net figure must be multiplied in order to discount it by a specified amount. It is calculated like this:

where "i" is the rate and "n" is the number of years hence. So assuming a rate of 6% and a forecast needed for year 2, the calculation would be:

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