Question

In finance, discounted cash flow (DCF) analysis is a common technique of placing value on a project or company. All of the future cash flows are projected and discounted by using cost of capital to determine their present values (PVs). Adding up all future cash flows, both incoming and outgoing, provides the net present value (NPV).

Respond to the following in a minimum of 175 words:

• Give an example of a situation where a building contractor may want to use the discounted cash flow (DCF) analysis method.
• Discuss a situation where a method to determine a project’s valuation, other than discounted cash flow (DCF) analysis, would be favorable.

Answer 1

Discounted cash flow is a technique used to derive the net present value of a project to determine if the project will have positive or negative present value.

For example: In case of a building contractor:Suppose initial investment in the project if R100,000,000. Cost of capital is 10% and cash flows during the next 5 years are:

Year	Cash flows
1	5,89,44,500.00
2	5,89,00,000.00
3	-5,83,95,000.00
4	5,72,82,000.00
5	1,34,88,000.00

Using the above data, we can identify the net present value of cash flows from the project to see if the project is viable or not.

If the NPV is positive, it means that the project generates positive cash inflow and it is viable to continue the project.

We derive NPV as follows:

Year	Cash flows	Discount factor@10%	Present value
0	-1,00,00,000.00	1.0000	-1,00,00,000.00
1	28,90,000.00	0.9091	26,27,299.00
2	48,94,450.00	0.8265	40,45,262.93
3	27,78,200.00	0.7514	20,87,539.48
4	33,49,900.00	0.6831	22,88,316.69
Net Present Value			10,48,418.10

Other than the discounted cash flow method, the building contractor can also use payback period/ discounted pay back period method which helps to measure the time the project will take to recover the investment made.

To understand it better, using the above data, refer the below working:

Year	Cash flows	Discount factor@10%	Present value	Cumulative Present Value
1	28,90,000.00	0.9091	26,27,299.00	26,27,299.00
2	48,94,450.00	0.8265	40,45,262.93	66,72,561.93
3	27,78,200.00	0.7514	20,87,539.48	87,60,101.41
4	33,49,900.00	0.6831	22,88,316.69	1,10,48,418.10
Net Present Value			1,10,48,418.10

From the above table, we can clearly see that R87,60,101.41 has been recovered till the 3rd year. The remaining initial investment amount (1,00,00,000 - 87,60,101,41= 12,39,898.60) is recovered in the 4th year.

Therefore time taken for remaining amount= 12,39,898.60/22,88,316.69= 0.54 years.

Therefore total discounted payback period is 3 years + 0.54 years= 3.54 years