Discounted Cash Flow Analysis

Discounted cash flow analysis is a method of valuing an asset using the concepts of the time value of money. Having one dollar today and one dollar in 1920 is not the same. The reason for this is inflation. Instead of inflation, one could take into account other parameters such as US Treasury Bonds returns. US treasury Bonds could be considered as almost risk free since it is guarantied by US government. For example, an arithmetic average (1928-2010) of annual returns on Treasury Bonds is about 5%.

We say that Future Value (or FV) is a value that is expected in some future, and that Present Value (or PV) is an actual value today. Relationship between Future Value and Present Value is given by the formula FV = PV * (1+i)^n. Having FV you can easily calculate PV = FV/(1+i)^n. Where i is an interest rate, and n is usually number of years.

Let's say that we have two offers for our house. The first one is $150,000 in two years, and the second one is $165,000 in four years. Which offer is better assuming other parameters equal? The second offer is obviously bigger, but is it better? It makes sense only to compare present values. Therefore we will compute PV for both offers.

The first offer:

From 150,000=PV*(1+5%)^2, we compute PV=150,000/(1+5%)^2=$136054

The second offer:

From 165,000=PV*(1+5%)^4, we compute PV=165,000/(1+5%)^4=$135746

Therefore the first offer is better. We took 5% as a low risk annual return.

The second offer might be better for different annual returns. Let's se what happens if we use 3% interest rate.

The first offer:

From 150,000=PV*(1+3%)^2, we compute PV=150,000/(1+3%)^2=$141389

The second offer:

From 165,000=PV*(1+3%)^4, we compute PV=165,000/(1+3%)^4=$146600

Therefore the second offer is better. We see that results of a comparison depends on interest rate you choose. For different problems you might choose different interest rates. For example, for real estates you might choose a conservative (low) rate , and for IT industry you might choose a higher rate.

Things could get more complicated if we there are several cash flow. We should do the math for every one of them. Let's say that we have two offers. The first one is $100,000 in two years and $60,000 in four years. The second one is $31,000 per year for the next five years.

The first offer:

$100,000 in two years would be $90703 today, while $60,000 would be $49362. The total is $140.065

The second offer would yield: 29524+28118+26779+25504+24289 which is 134214.

Therefore the first offer is better.