Discounted net present cash flow analysis

7.3 Discounted net present cash flow analysis

To assess a possible investment, we must take the time value of money into account [3]. We could invest the f1,000 in risk-free state-bonds, which are guaranteed to pay out a certain interest over the investment. Suppose that this interest is 5%. The an investment of f1,000 in state bonds will grow to f1,000 × 1.05 = f1,050 after one year.

Reasoning the other way around, we will have f1,000 in one year if we invest f952.38 now in risk-free state bonds at 5% interest. We say that the net present value of f1,000 next year is f952.38 now, or that f1,000 next year is discounted to f952,38 now.

In general, the possession of fX n years from now, is worth fY now, if we can make Y grow into X according to the best, risk-free opportunity available to us now. Discounting a future amount X to its current value Y incorporates our estimate of what is the best risk-free opportunity available to us now.

As a consequence, the same amounts of money in different future contract periods have a different discounted value today.

In realistic situations, many consecutive contract periods are needed to earn back an investment. To assess the value of an investment and compare it to a risk-free investment is state bonds, all money values in these consecutive periods should be discounted to the same time period. Usually this is period 0, the time at which the investment was made.

To calculate the net discounted present cash for a series of time periods, the following formula for Discounted Net Present Cash (DNPC) Flow calculation can be used:

∑m (Revenuesp-− Expensesp-−-Investmentsp) p=0 (1+ interest)p

where p ranges over the time periods of the time series.

Using this formula for the investments, revenues, and expenses in table 7.1, using an interest rate of 5 %, results in table 7.2. The net revenue of f400 generated in each period is worth less the farther the period lies in the future. The value of our investment is now only f89.30.

Table 7.2:Calculation of discounted net present cash value over a series of market scenarios using 5% interest


Period	Revenues	Expenses	Investments	DNPC


0			1,000	-1,000

1	500	100		380.85

2	500	100		362.81

3	500	100		345.54


Total				89.30