Considering the Discounted Cash Flow

Discounted cash flow accounts for the time value of money. If you were to borrow $100,000 for five years from your uncle, you'd be paying interest on the money, yes? (If not, you've got a great uncle.) If the $100,000 were invested for five years and managed to earn a whopping 6 percent interest per year, compounded annually, it'd be worth $133,822.60 at the end of five years. This is the future value of the money in today's terms. The magic formula for future value is FV = PV (1 + I)n, where:

• N is the number of time periods (years, quarters, and so on) Here's the formula with the $100,000 in action:

The future value of the $100,000 five years from now is worth $133,822.60 today. So how does that help? Now we've got to calculate the discounted cash flow across all of the projects up for selection. The discounted cash flow is really just the inverse of the preceding formula. We're looking for the present value of future cash flows: PV = FV+(1 + I)n.

In other words, if a project says it'll be earning the organization $160,000 per year in five years, that's great, but what's $160,000 five years from now really worth today? This puts the amount of the cash flow in perspective with what the projections are in today's money. Let's plug it into the formula and find out (assuming the interest rate is still six percent):

So...$160,000 in five years is really only worth $119,561 today. If we had four different projects of varying time to completion, cost, and project cash inflows at completion, we'd calculate the present value and choose the project with the best present value, as it'll likely be the best investment for the organization.

EXAM TIP You should be able to look at the present value of two proposed projects and make a decision as to which one should be green-lighted. The ^I^BB project with the highest present value is the best choice if that's the only factor you're presented with.

Project Management Made Easy

Project Management Made Easy

What you need to know about… Project Management Made Easy! Project management consists of more than just a large building project and can encompass small projects as well. No matter what the size of your project, you need to have some sort of project management. How you manage your project has everything to do with its outcome.

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