What is Net Present Value? What is a Discounted Cash Flow? And how are they different? Business owners and/or investors need to thoroughly understand these terms to maximise their benefits. Read on to learn more.
Understanding the logic behind Net Present Value (NPV) and a Discounted Cash Flow (DCF) and identifying the benefits each can offer business owners and/or investors will no doubt help them maximise on future investment opportunities.
To begin, business owners first need to accurately differentiate one from the other. This can be done by thoroughly understanding each concept first:
- What is Net Present Value (NPV)?
- What is a Discounted Cash Flow (DCF)?
What is Net Present Value (NPV)?
The difference between the current value of cash inflows and the current value of cash outflows, the NPV sees utilisation in capital budgeting when an analysis on a projected investment or financed venture is called for or simply necessary.
In general, when an investment shows a positive net present value, it is deemed as highly profitable. A positive NPV indicates that the projected future returns on investment generated by the projected or financed venture will be higher than the expected costs. It follows, then, that a negative NPV means net loss.
This premise is the core of the net present value rule, which dictates that if one expects good returns of investment, only take up prospective business/investment ventures with positive NPV values.
Remember that sometimes, determining the value of a prospective venture can become quite complex, since there are a number of ways to arrive at a measurement of the value of future cash flows.
This complexity might be brought about by earnings that could be made during the course of the intervening time, and because of inflation—a very real, and very important factor that needs to be accounted for when trying to determine the NPV.
To mitigate possible complexities in determining the net present value, account for the discount rate of the NPV formula. Bear in mind that different businesses and companies also have different methods in arriving at a discount rate, probably because each business accounts for their own specific business situation and investment realities.
However, the most commonly utilised methods in arriving at a discount rate involves using the expected returns of other investment alternatives with the same or similar level(s) of risk.
What is a Discounted Cash Flow (DCF)?
The DCF determines the attractiveness of an investment opportunity through an analysis utilising informed projections of future free cash flows and then discounting them to determine a learned estimation of a present value. The present value will then be utilised in the assessment and evaluation of the potential for investment.
A good investment opportunity is usually indicated by a resulting value higher than the cost of the investment.
Note that in a DCF analysis, several variations to cash flows value assignment should be expected, as well as the discount rate. But always remember that though the process might get a little complex—depending on the specific business situation, as well as your business and/or investment objectives—the purpose of the DCF method and its entailing analyses is simply to help business owners understand,how much they would receive a prospective investment.
NPV versus DCF
From the discussion on each term above, it can now be deduce that what the NPV really does is look into what a future cost is worth in today’s Australian Dollars (or any other currency specific to your business situation).
On the other hand, the DCF helps in figuring out how much investment is needed to make in the present time in order to achieve the expected/desired payment or investment in a foreseeable time in the future.
Furthermore, the NPV accounts for the fact that the other party or parties will have the benefit of using the amount in the meantime, as well as getting the compounding effect from the said course of action. These possible circumstances would mean the money would now be worth less to the business owner, that is if they are not enjoying the compounding effect of the amount.
On the other hand, the DCF is focused on the fact that they will enjoy the benefits of the investment by earning good returns and also benefiting from the compounding effects of the said amount in the interim. This would mean the amount invested today for a payment sometime in the future is less than the payment amount.
So what is one of the most glaring differences between the two? It’s when business owners will get the payment/returns.
The NPV compares the value of the investment amount today to its value in the future, while the DCF assists in analysing an investment and determining its value—and how valuable it would be—in the future.
From here, we can say that the NPV is a part of the DCF, an essential one at that. Thus, in investing, always go for the positive NPVs, and fortify your future investment benefits by utilising an effective DCF method.
- The NPV is an essential component of the DCF
- The NPV is useful in comparing internal and external investments
- The DCF method makes it clear how long it would take to get returns
- The NPV = Cash inflow(s) value - Cash outflow(s) value
- The DCF = Investors’ most reliable tool
The NPV is an essential component of the DCF
Based on the discussion, it can now be said that the NPV is really an essential component of the DCF, as the NPV is one of the most important tools in effecting and strengthening the DCF method and maximising on its resulting benefits.
The NPV is useful in comparing internal and external investments
Representing the present value of cash flows, the NPV is generally used in the comparison of both internal and external investments in a business or company, assisting business owners in their business and investment decision-making process.
The DCF method makes it clear how long it would take you to get returns
Aside from helping business owners come up with a well-informed projection of returns from their investments, the DCF method also makes clearer how long it would take for them to get such returns.
The NPV = Cash inflow(s) value - Cash outflow(s) value
Basically, the NPV is the difference between present values of cash inflow(s) and cash outflow(s).
The DCF = Investors’ most reliable tool
Investors who want to make sure they enjoy will great returns in the future utilise the Discounted Cash Flow method, especially on bonds, stocks, and real estate investments.
If they are still unsure or unclear about some of the concepts and specifics, business owners should never hesitate to engage the services of a trusted accountant, investments consultant, or other relevant professionals with proven expertise on NPV and DCF, and their entailing business and investment implications.