The discounted cash flow method is designed to establish the present value of a series of future cash flows. Present value information is useful for investors, under the concept that the value of an asset right now is worth more than the value of that same asset that is only available at a later date. An investor will use the discounted cash flow method to derive the present value of several competing investments, and usually picks the one that has the highest present value. The investor may not pick an investment with the highest present value if it is also considered a riskier opportunity than the other prospective investments.
The steps to be taken to calculate present value under the discounted cash flow method are as follows:
- Itemize all positive and negative cash flows associated with an investment. This can include the following:
- The initial purchase
- Subsequent maintenance on the initial purchase
- The working capital investment associated with the initial purchase
- The profit on sales of the goods and services derived from the investment
- The amount of income tax sheltered by the depreciation on the acquired asset
- The working capital reduction that occurs once the asset is later sold
- The salvage value of the asset that is expected when it is sold at the end of its useful life
- Determine the cost of capital of the investor. This is the after-tax cost of the investor's debt, preferred stock, and common stock. It may also be adjusted upward to account for the additional risk associated with an investment. The cost of the investor's common stock is the most expensive and the most difficult to calculate. For more information, see our cost of capital article.
- Plug the cash flows from Step 1 and the cost of capital from Step 2 into the following calculation to derive the present value of all cash flows:
Net present value = X × [(1+r)^n - 1]/[r × (1+r)^n]
X = The amount received per period
n = The number of periods
r = The required return (cost of capital)
The preceding formula can be plugged into the Excel electronic spreadsheet to arrive at the discounted cash flow figure.