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 after-tax 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
Inflows

Year 2 Cash
Inflows

Year 3 Cash
Inflows

Year 4 Cash
Inflows

Year 5 Cash
Inflows

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
Inflows

Year 2 Cash
Inflows

Year 3 Cash
Inflows

Year 4 Cash
Inflows

Year 5 Cash
Inflows

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

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