Discounted cash flow - what's it worth in the future?

Discounted cash flow (DCF) is the most complex of the three methods we are looking at here, but has the main advantage that it takes account of the
fact that returns in the future may be worth less than the same return now. This would seem obvious to you if you were offered either £5,000 now or
£5,000 in three years time - which would you accept? Of course you'd want the money now, because if you took the £5,000 and put it in the bank for
three years (if you could stop yourself spending it!), then it would be worth a lot more - £6,655 at an interest rate of 10%. Discounting future returns is
the same in principle, but in reverse. We say that if you have a return of £6,655 in three years time, then this will be worth £5,000 now - we discount the
future returns by the amount of the interest rate, which we call the discount rate. Another way of looking at it is to ask how much you would need to put
into a bank today to earn a specific amount in x years time.

We can work this out mathematically, but generally you would be given discount tables that tell you how much less a return is worth each year. Below is
an example of a discount table for three different interest rates:

Years in future 8% 10% 12%

Year 1 0.926 0.909 0.893
Year 2 0.857 0.826 0.797
Year 3 0.794 0.751 0.712
Year 4 0.735 0.683 0.636
Year 5 0.681 0.621 0.567

As an example, at a rate of 8% you would need to invest just over 68p now to earn £1 in five years time. So, for example, to get the discounted value of
£20,000 in 4 years time at a discount rate of 10%, we would multiply the £20,000 by 0.683, giving us a present value of £13,660.

To use this to value an investment project, we would go through the following steps:

• Choose an appropriate discount rate (this may depend on expected future interest rates in the market).

• Multiply the expected net cash flows over the lifetime of the project by their discount factor (as in the table above).

• Add together all the present values from step 2 and subtract the capital cost to give us the net present value.

Let's do an example to see how this works. A firm is thinking of buying a machine costing £200,000 and the expected net cash flows are:

Year 1 2 3 4 5
Net cash flow (£) 50,000 55,000 65,000 75,000 75,000

If we follow the three steps above, we will get:

Step 1

Let's choose a discount rate of 10%. This means that our discount factors are:

Years in future 10%

Year 1 0.909
Year 2 0.826
Year 3 0.751
Year 4 0.683
Year 5 0.621
Step 2

If we multiply the expected net cash flow by the discount factor, we get:

Year 1 2 3 4 5
Net cash flow (£) 50,000 55,000 65,000 75,000 75,000
Discount factor 0.909 0.826 0.751 0.683 0.621
Present value (£) 45,450 45,430 48,815 51,225 46,575
Step 3

If we add all these present values together and subtract the capital cost, we get:

£237,495 - £200,000 = Net present value of £37,495

This represents quite a small return of 18.7% over 5 years on the original investment. The average rate of return calculation gives us a result of
12% per annum on these same figures and so discounting the future value of returns does give a very different picture.