Discounted cash flows (DCF)
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
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
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
that discount rate.
The Excel setup with a 10% discount rate and five years of cash
0.5 = NPV(10%, -44.7, 16.0, 14.7, 13.9, 11.9)
Making judgments using NPV
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
alternative investment. If the NPV is less than zero, it would be worse.
Compounding and Discounting
The Terminal Value - It's Mature