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Why Are Cash Flows Discounted?

The cash flows in net present value analysis are discounted for two main reasons, (1) to adjust for the risk of an investment opportunity, and (2) to account for the time value of money (TVM).

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In practical terms, it is taking all the money that we hope to obtain from an investment and transferring those returns to today's values ​​with which we can decide whether or not the investment is worth making.

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This is where the net present value (VPN) technique comes into play. The net present value is the equivalent value today of the cash flows of future years, which when demanded at a discount rate or minimum required return, can be compared with the value of an initial investment made in the present .

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Many projects generate revenue at varying rates over time. In this case, the formula for NPV can be broken out for each cash flow individually. For example, imagine a project that costs $1,000 and will provide three cash flows of $500, $300, and $800 over the next three years. Assume there is no salvage value at the end of the project and the required rate of return is 8%. The NPV of the project is calculated as follows:

N
P
V
=
$
5
0
0
(
1
+
0
.
0
8
)
+
$
3
0
0
(
1
+
0
.
0
8
)
+
$
8
0
0
(
1
+
0
.
0
8
)
−
$
1
0
0
0
=
$
3
5
5
.
2
3
 
NPV
​	  
= 
(1+0.08) 
1
 
$500
​	Examples Using NPV
Many projects generate revenue at varying rates over time. In this case, the formula for NPV can be broken out for each cash flow individually. For example, imagine a project that costs $1,000 and will provide three cash flows of $500, $300, and $800 over the next three years. Assume there is no salvage value at the end of the project and the required rate of return is 8%. The NPV of the project is calculated as follows:

N
P
V
=
$
5
0
0
(
1
+
0
.
0
8
)
+
$
3
0
0
(
1
+
0
.
0
8
)
+
$
8
0
0
(
1
+
0
.
0
8
)
−
$
1
0
0
0
=
$
3
5
5
.
2
3
 
NPV
​	  
= 
(1+0.08) 
1
 
$500

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Many projects generate revenue at varying rates over time. In this case, the formula for NPV can be broken out for each cash flow individually. For example, imagine a project that costs $1,000 and will provide three cash flows of $500, $300, and $800 over the next three years. Assume there is no salvage value at the end of the project and the required rate of return is 8%. The NPV of the project is calculated as follows:

N
P
V
=
$
5
0
0
(
1
+
0
.
0
8
)
+
$
3
0
0
(
1
+
0
.
0
8
)
+
$
8
0
0
(
1
+
0
.
0
8
)
−
$
1
0
0
0
=
$
3
5
5
.
2
3
 
NPV
​	  
= 
(1+0.08) 
1
 
$500
​	Examples Using NPV
Many projects generate revenue at varying rates over time. In this case, the formula for NPV can be broken out for each cash flow individually. For example, imagine a project that costs $1,000 and will provide three cash flows of $500, $300, and $800 over the next three years. Assume there is no salvage value at the end of the project and the required rate of return is 8%. The NPV of the project is calculated as follows:

N
P
V
=
$
5
0
0
(
1
+
0
.
0
8
)
+
$
3
0
0
(
1
+
0
.
0
8
)
+
$
8
0
0
(
1
+
0
.
0
8
)
−
$
1
0
0
0
=
$
3
5
5
.
2
3
 
NPV
​	  
= 
(1+0.08) 
1
 
$500

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Examples Using NPV

Many projects generate revenue at varying rates over time. In this case, the formula for NPV can be broken out for each cash flow individually. For example, imagine a project that costs $1,000 and will provide three cash flows of $500, $300, and $800 over the next three years. Assume there is no salvage value at the end of the project and the required rate of return is 8%. The NPV of the project is calculated as follows:

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What does the net present value tell you?

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What does the net present value tell you?

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The present value is the part of the net present value formula where projected cash flows for each year are discounted by a certain rate

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NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.

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TítAdvantages Disadvantages
• It considers both the timing of cash flows and their size in
arriving at an appraisal.
• The rate of discount can be varied to allow for different
economic circumstances. For instance, it could be increased
if there was a general expectation that interest rates were
about to rise.

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It is reasonably complex to calculate and to explain –
especially to non-numerate managers!
• The final result depends greatly on the rate of discount used,
and expectations about interest rates may be inaccurate.
• Net present values can be compared with other projects, but
only if the initial capital cost is the same. This is because the
method does not provide a percentage rate of return on the
investment (internal rate of return).

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Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.