The heart of discounted cash flows analysis is the assumptions behind the numbers. Once the mechanics of the tool are mastered, then one needs to focus on the assumptions behind the numbers. How might a manager manipulate the assumptions behind a discounted cash flows analysis of a project to ensure a favorable result (e.g. positive NPV)? If you are in a position to review and approve capital projects that have been evaluated using DCF techniques, how should you guard against being manipulated?
The idea behind discounting future cash flow is to convert future cash sums into present value in order to understand and determine the actual value of the future cash flows. This results in being able to make an informed decision related to actually undertaking an investment project.
Some of the assumptions behind this model relate to the actual discount factor used, what it entails and how it impacts the calculations, and what it means to the value of the actual investment.
Typically, the discount factor relates to one of three items (or can possibly be a result of viewing all three items):
* net present value (NPV) which relates to the return currently being reflected by the firm, and is usually represented by the ratio of net profit to sales, and/or net profit to assets;
* the internal rate of return (IRR) which relates to the cost of capital and the potential for covering that cost through long term investment projects;
* the payback period usually subjectively determined as the time period acceptable to the firm for returning the initial outlay to the firm. Further, it can also be reflected as the discounted payback period, which uses the discount factor to include the real term for payback after including the risk elements within the calculations.
Any or all of the above can be used by the firm to determine if ...
This solution looks at long-term investments and the assumptions behind discounted cash flow analysis. It determines the risk and calculation elements with long-term investing like NPV and IRR.