DISCOUNT CASH FLOW AND ITS METHOD
In recent years, the discounted cash flow or D.C.F. techniques have been applied for assisting in making decision relating to property investment and appraisal. These techniques serves as an aid to the valuation of any investment producing a cash flow and sometimes a valuer may be consulted to give an expert opinion whether a development project covers its cost including the interest charges for borrowing the capital and leaves over a surplus towards profits so as to justify its implementation.
Following are the two principal methods of DCF Calculation.
Net Present Value Method
When the present value of the all the future cash flows generated from a project is added together (whether they are positive or negative) the result obtained will be the Net Present Value or Net Present Value Method. The concept is having great importance in the field of finance and investment for taking important decisions relating to cash flows generating over multiple years. Net Present Value Method constitutes shareholder’s wealth maximization which is the main purpose of the Financial Management.
Net Present Value Method shows the actual benefit received over and above from the investment made in the particular project for the time and risk. Here, one rule of thumb is followed, accept the project with positive Net Present Value Method and reject the project with negative Net Present Value Method. However, if the Net Present Value Method is zero, then that will be a situation of indifference i.e. the total cost and profits of either option will be equal. The calculation of Net Present Value Method can be done in the following way:
NPV = Discounted Cash Inflows – Discounted Cash Outflows
Internal rate Return:
Internal rate Return for a project is the discount rate at which the present value of expected net cash inflows equates the cash outlays. To put simply, discounted cash inflows are equal to discounted cash outflows. It can be explained with the following ratio,
(Cash inflows / Cash outflows) = 1.
At IRR, NPV = 0 and PI (Profitability Index) = 1
In this method, the cash inflows and outflows are given. The calculation of the discount rate, i.e. Internal rate Return, is to be made by trial and error method.
The decision rule related to the Internal rate Return criterion is: Accept the project in which the Internal rate Return is greater than the required rate of return (cut off rate) because in that case, the project will reap the surplus over and above the cut-off rate will be obtained. Reject the project in which the cut-off rate is greater than Internal rate Return, as the project, will incur losses. Moreover, if the Internal rate Return and Cut off rate are equal, then this will be a point of indifference for the company. So, it is at the discretion of the company, to accept or reject the investment proposal.
