Discounted cash flow information and application
4. Net present value
Managers need to know the value of a multiyear project in terms of today’s dollars, which will be used to make the initial investment. The net present value is found by discounting all estimated future cash flows to present value, then comparing the initial cost of the project to the sum of the discounted cash flows. When applying this method, it is usually preferable to consider cash inflows on an aftertax basis. In addition, tax costs and savings due to different depreciation rates need to be considered as cash flows. We’ll now go over an example of how to find net present value.
Company X management requires a 12% return on all investments. The company is currently considering the following three investments:
Initial Cost 
Year 1 Cash 
Year 2 Cash 
Year 3 Cash 
Year 4 Cash 
Year 5 Cash 

Investment A 
(100,000) 
27,000 
27,000 
27,000 
27,000 
27,000 
Investment B 
(100,000) 
0 
0 
20,000 
50,000 
90,000 
Investment C 
(100,000) 
50,000 
30,000 
20,000 
15,000 
15,000 
Present value factors are as follows:
Number of Periods 

Discount Rate 
1 
2 
3 
4 
5 
12% 
0.893 
0.797 
0.712 
0.636 
0.567 
The first step is to discount all cash flows from the first chart. This is simply a matter of multiplying the annual cash flows by the relevant time value factors. For instance, the $25,000 cash flow from Investment A in year 1 would be multiplied by 0.893; 0.893 represents a time value factor for year 1 at a rate of 12% and can be calculated as: 1/(1+12%)^{1}. We can now reproduce the first chart, but this time with discounted amounts:
Initial Cost 
Year 1 Cash 
Year 2 Cash 
Year 3 Cash 
Year 4 Cash 
Year 5 Cash 

Investment A 
(100,000) 
24,111 
21,519 
19,224 
17,172 
15,309 
Investment B 
(100,000) 
0 
0 
14,240 
31,800 
51,030 
Investment C 
(100,000) 
44,650 
23,910 
14,240 
9,540 
8,505 
By subtracting the initial cost from the sum of all discounted cash flows, we can find net present value. Under the constraints set by management, we can see that only Investment C should be made:
Investment A: 24,111 + 21,519 + 19,224 + 17,172 + 15,309 – 100,000 = ($2,665)
Investment B: 14,240 + 31,800 + 51,030 – 100,000 = ($2,930)
Investment C: 44,650 + 23,910 + 14,240 + 9,540 + 8,505 – 100,000 = $845