Discounted cash flow (DCF) and net present value (NPV)

Discounted cash flow, or DCF, converts expected future cash flows into today’s value. Net present value, or NPV, adds the discounted inflows and outflows associated with an investment. Together they allow decision makers to compare the capital committed now with the value expected later, after accounting for time and risk.

When to use it

Use DCF and NPV in capital budgeting and investment appraisal to decide:

• which projects should be accepted;
• how much capital expenditure the firm should undertake;
• how a selected portfolio should be financed.

Include only relevant incremental cash flows—future cash flows that differ among alternatives. The discount rate should reflect the time value of money and the risk of the forecast cash flows. A positive NPV indicates that the project is expected to earn more than the selected required return, given the assumptions.

Origins

Present-value reasoning grew from centuries of interest and annuity calculation, with industrial applications appearing by the early nineteenth century. Irving Fisher provided the modern economic foundation for intertemporal value in The Theory of Interest. John Burr Williams applied discounted future cash flow to investment valuation in The Theory of Investment Value, published in nineteen thirty-eight. NPV later became a standard corporate-finance rule for comparing discounted project inflows and outflows.

What it is

DCF discounts each expected cash flow according to when it occurs and the return required for its risk. NPV is the total of those present values, including the initial investment: NPV = Σ CFₜ/(one + r)ᵗ. A result above zero supports investment on financial grounds; a result below zero suggests the forecast return does not meet the hurdle rate. The arithmetic is mechanical, but cash-flow, terminal-value and discount-rate assumptions require judgement.