Discounted Cash Flow
Time Value of Money. The discounted cash flow model for capital budgeting decision recognizes the time value of money. A rupee in hand today is worth more than a rupee to be received (or spent) several years from now. This is because the use of money has a cost (interest), just as the because the use of money has a cost (interest), just as the use of a building may have a cost (rent). For example, a rupee invested today, say in a bank would grow as time goes by because of the interest it would earn. Thus, in evaluating investment projects, it is important to consider the magnitude and timing of expected returns or cash flows in each period of a project’s life.
Discounted cash-flow methods is an improvement overall the other models of capital budgeting and is regarded as the best decisions model for capital investment, for it provides a more objective basis for evaluating and selecting investment projects. Because this method explicitly and automatically weights the time value of money. It is the best method to use for long range decisions (Horngren). Another major aspects of this method is its focus on cash inflows and outflows rather than on net income as computed in the conventional accounting sense.
Discounted cash flow method enable us to isolated differences in the timing of cash flows to their present values. The present values can then be analyzed to determine the desirability of the projects. Since a rupee in hand today is worth more than a rupee in hand today is worth more than a rupee received in later years, the present value of future stream of income (cash flows) will always be less, depending upon the timing or receipts and the discount ratio (or the compound interest and the bond yields in reverse direction).
The present value of rupee one received in different time periods and to be discounted at varying rates can be had from the present value table which is nothing more than a bond yield table that takes account of compound interest Mathematically, the present value of Re. 1 received at the end of the year in is :
PV = 1/(1+k)n
Where PV is the present value and k is the discount rate. Thus, rupee one received at the end of the first and second year will result in the following present value at a discount rate 10%.
(i) End of 1st Year : PV = 1/(1+0.10) =1/90 = 0.90909
(ii) End of 2nd Year : PV = 1/(1+0.10)2 =1/1.21 = 0.8264
The present value of any amount received in later years can be obtained by multiplying the amount with the appropriate discounted factor (present value) of rupee one. Fortunately, a present value table has been prepared that relieves us of making the calculations for present value every time we have a problem to solve. By reference to the appropriate columns of the table we can always get the desired present value of rupee one. (The Present Value Table is given at the end of this lesson).