What is the definition of discounted cash flow?
Hello, Another method of calculating the expected rates of return of discounted cash flow is the present value method. This method is also popularly known as the discounted cash flow method. This method involves calculating the present value of cash benefits at a rate equal to the firm’s cost of capital. Which in other words, (The present value of an investment is the maximum amount that this firm can pay for the opportunity to invest, and which is deteriorating financially.)
This compares the current values with the costs of the financial executive proposal. Or if at present the value is more than the net investment, then it becomes necessary to accept the proposal. On the contrary, if the present value is smaller than the net investment, this return is less than the cost of financing. In this case, investing will result in a financial loss to the firm. There are four ways to judge the profitability of different proposals based on the technique formula given below. So let’s throw light into it.
1. Net present value method
This method is also known as the extant present value or net gain method. Which to implement this approach, we only find out the current value of the expected net cash of the investment discounted at the cost of capital. And deduct it from the initial cost outlay of the project. If this net present value is positive, then this project must be accepted: if it is negative, it should be rejected.
(NPV = Total Present value of cash inflows – Net Investment)
If these two projects are mutually exclusive, then this higher net present value should be chosen. As below, the following example procedure has been questioned. If you assume that it is a firm’s cost of capital after taxes is 6%. So in addition, assume that the net cash-flow (after taxes) is Rs. 5,000 investment is estimated to be 2,800 per year for 2 years. (The present value of this stream of net cash-flow with a discount of 6% comes to 5,272 (1,813 x 2800).
|Therefore, the present value of the cash inflow||=||Rupees- 5,272|
|Less present value of net investment||=||Rupees- 5,000|
|Net Present value||=||Rupees- 272|
2. Internal rate of return method
This method is popularly known as the time adjusted rate of return method and the discounted rate of return method. This is the internal rate of return defined as the interest rate. And which equates the present value of future receivables to the cost of investment outlay. Whose internal rate of return is met with trial and error. And first of all, we calculate the present value of the cash-flow from investment using an arbitrarily selected interest rate.
And then we compare the present value received with the investment value. If this present value is higher than the cost figure, then we try a higher rate of interest. And undergo the process again. Conversely, if the present value is less than the cost, lower the interest rate, and repeat the process. The interest rate that comes about in this parity is defined as the internal rate of return.
Which this rate of return is compared to the cost of capital. And there is a high difference in the project so that if they are mutually exclusive, it is adopted, and the other is rejected. As the determination of the internal rate of return involves a number of attempts to make the present value of earnings equal to the investment, this approach is also referred to as the trial and error method:
3. Profitability index method
This is a major disadvantage of the current value method. It is not particularly easy to rank projects on the basis of net present value when the cost of projects varies significantly. And the current price profitability index is prepared to compare such projects. The following index establishes the relationship between cash flow and investment amount as per the given formula. Let’s throw light on that.
V. Index = —————- x 100 or ——————– x 100
For example, the profitability index of the Rs. 5,000 investment discussed in Net Present Value Method above would be:
—————-X100=5.44 or —————-X100=105.44
This higher profitability index, which makes it a more desirable investment. And in this way, this index provides ready compatibility of investments of different magnitude. By calculating profitability indices for various projects as a whole, then financial managers can rank them in order of their respective rates of profitability.
4. Terminal value method
All these approaches differentiate cash flow times. Excludes more specifically. Which is the assumption behind this approach, that each cash-inflow is reinvested into other assets at a fixed rate of return from this point onwards, and it is received until the completion of the project? Then the present value of the total mixed amount is calculated. And this is also compared to the initial cash-outflow. The decision rule is that, if the present value of the aggregate amount of reinvested cash flows exceeds the present value of cash, then this proposed project is accepted. Which it is not otherwise. Or if both values are equal.
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