2.2 Discounted Cash Flow Applications - 2.2 Discounted Cash Flow Applications

Key Concepts

• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Discounted Payback Period
• Profitability Index

Net Present Value (NPV)

Net Present Value (NPV) is a method used to determine the current value of all future cash flows generated by a project, discounted at the appropriate rate. A positive NPV indicates that the project is expected to generate more value than it costs, making it a worthwhile investment.

Example: Suppose a project requires an initial investment of $100,000 and is expected to generate cash flows of $30,000, $40,000, and $50,000 over the next three years. If the discount rate is 10%, the NPV can be calculated as follows:

NPV = -$100,000 + ($30,000 / (1 + 0.10)^1) + ($40,000 / (1 + 0.10)^2) + ($50,000 / (1 + 0.10)^3)

If the NPV is positive, the project is considered viable.

Internal Rate of Return (IRR)

Internal Rate of Return (IRR) is the discount rate at which the NPV of a project equals zero. It represents the expected annual rate of return for the project. A higher IRR indicates a more attractive investment opportunity.

Example: Using the same project as above, the IRR is the rate at which the sum of the discounted cash flows equals the initial investment. If the IRR is higher than the required rate of return, the project is considered profitable.

Discounted Payback Period

The Discounted Payback Period is the time it takes for the cumulative discounted cash flows to equal the initial investment. It helps in understanding how long it will take to recover the initial investment, considering the time value of money.

Example: If a project requires an initial investment of $100,000 and generates discounted cash flows of $25,000, $30,000, and $35,000 over three years, the discounted payback period is the time when the cumulative discounted cash flows reach $100,000.

Profitability Index

The Profitability Index (PI) is the ratio of the present value of future cash flows to the initial investment. A PI greater than 1 indicates that the project is expected to generate more value than it costs, making it a good investment.

Example: If the present value of future cash flows for a project is $120,000 and the initial investment is $100,000, the Profitability Index is calculated as follows:

PI = $120,000 / $100,000 = 1.2

A PI of 1.2 indicates that the project is expected to generate 20% more value than the initial investment.