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Discounted cash flows and net present value

Discounted cash flows (DCF)

We estimate how much we will spend or make for a number of periods in the future, a series of cash flow we estimate for an action plan.

What is the rate of growth or decline - the internal rate of return (IRR)? Using Excel's IRR function for the example, 10.6% is the internal rate of return that explains this flow of funds.

Net Present Value (NPV)

A better question to ask is: will the cash flows return more than making the same investment of \$44.70 in another opportunity with a known rate of return, for example, for an AAA corporate bond at 10.0%? When you use Excel to calculate NPV, you provide that discount rate. The Excel setup with a 10% discount rate and five years of cash flows is:

0.5 = NPV(10%, -44.7, 16.0, 14.7, 13.9, 11.9)

Making judgments using NPV

The NPV of 0.5 is positive, so it is better to invest in the project. That makes sense; the IRR in the example for discounted cash flows above was 10.6%, slightly better than the threshold discount rate 10% we used in the NPV calculation. If NPV were zero, it would be the same as the alternative investment. If the NPV is less than zero, it would be worse.

The Terminal Value - It's Mature

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