DISCOUNTED CASH FLOW (DCF)

The discounted cash flow (DCF) analysis, in financial analysis, is a method used to
value a security, project, company, or asset that incorporates the time value of
money. Discounted cash flow analysis is widely used in investment finance, real
estate development, corporate financial management, and patent valuation. Used in
industry as early as the 1700s or 1800s, it was widely discussed in financial
economics in the 1960s, and U.S. courts began employing the concepts in the
1980s and 1990s

Discounted cash flow calculations have been used in some form since money was
first lent at interest in ancient times, Studies of ancient Egyptian and Babylonian
mathematics suggest that they used techniques similar to discounting cash flow
analysis has been used since at least the early 1700s in the UK coal industry.

Discounted cash flow valuation is differentiated from the accounting book value,
which is based on the amount paid for the asset.
CAPITAL BUDGETING

In corporate finance, corporate planning and accounting is an area of capital

management that concerns the planning process used to determine whether an
organization’s long term capital investments such as new machinery, new plants,
new products, and research development projects are worth the funding of cash
through the firm’s capitalization structures (debts, equity or retained earnings) it
is the process of allocating resources

Capital budgeting in corporate finance, corporate planning and accounting is an

area of capital management that concerns the planning process used to determine
whether an organization’s long term capital investments such as new machinery,
replacement of machinery, new plants, new products, and research development
projects are worth the funding of cash through the firm’s capitalization structures.

Capital budgeting is typically considered a non-core business activity as it is not

part of the revenue model or models of most types of firms, or even a part of daily
operations. It holds a strategic financial function within a business. One example of
a firms, or even a part of daily operations. It holds a strategic financial function
within a business.

METHODS OF CAPITAL BUDGETING

The five primary capital budgeting techniques are net present value (NPV),
internal rate return (IRR), payback period, profitability index (PI), and modified
internal rate return (MIRR), each techniques evaluates investment proposals
differently to determine their financial viability.
PAYBACK PERIOD METHOD (PPM)

The payback period is the amount of time it would take for an investor to recover a
project’s initial cost. It’s closely related to the break-even point of an investment.

Payback period is a quick and easy way to assess investment opportunities and
risk, but instead of a break-even analysis’s units, payback period is expressed in
years. The shorter the payback period the more attractive the investment would be,
because this means it would take less time to break even.

Payback period is used not only in financial industries, but also by businesses to
calculate the rate of return on any new asset or technology upgrade.

HOW TO CALCULATE PAYBACK PERIOD

To determine how to calculate payback period in practice, you simply divide the
initial cash outlay of a project by the amount of net cash inflow that the project
generates each year. For the purposes of calculating the payback period formula,
you can assume that the net cash flow is the same each year. The resulting number
is expressed in years of fractions of years.

FORMULEA FOR THE PAYBACK PERIOD

Written out as a formulae, the payback period calculation could also look like this:

Payback period- Initial Investment/Annual Payback

HOW DO YOU CALCUATE PAYBACK PERIOD METHOD

To calculate the payback period you can use the mathematical formula: Payback
Period-Initial Investment/Cash Flow Per Year.
AVERAGE RATE OF RETURN (ARR)

Average Rate of Return (ARR) refers to the percentage rate of return expected on
investment or asset is the initial investment cost or average investment over the life
of the project, The formula for an average rate of return is derived by dividing the
average annual net earnings after taxes or return on the investment by the original
investment or the average investment during the life of the project and then
expressed in terms of percentage.

FORMULA FOR AVERAGE RATE RETURN

Mathematically, it is represented as,

Average Rate of Return Formula-Average Annual Net Earning After Taxes/Initial

Investment*100%

The formula for the calculation of the average return can be obtained by using the
following steps:

1. Firstly, determine the earnings from an investment, say stock, options, etc, for a
significant time, say five years. Now, calculate the average annual return by
dividing the summation of the earnings by the no of years considered.

2. Next, in case of a one-time investment, determine the initial investment in the

asset. In the case of regular investments, the average investment over life is
captured.

3. Finally, the calculation of the average return is done by dividing the average
annual return (step 1) by initial investment in the asset (step 2) it can also be
derived by return formula to understand it better.
NET PRESENT VALUE (NPV)

Net present value (NPV) is the difference between the present value of cash
inflows and the present value of cash outflows over a period of time. NPV is used
in capital budgeting and investment planning to analyze the profitability of a
projected investment or project.

NPV is the result of calculations that find the current value of a future stream of
payments using the proper discount rate. In general, projects with a positive NPV
are worth.

NET PRESENT VALUE (NPV) FORMULA

NPV=Cash flow/ (1+i) t-initial

Where:

I= Required return or disclosed

T= Number of time periods

HOW TO CALCULATE NET PRESENT VALUE (NPV)

1. Net present value (NPV) is used to calculate the current value of a future stream
of payments from a company, project, or investment.

2. To calculate NPV, you need to estimate the timing and amount of future cash
flows and pick a discount rate equal to the minimum acceptable rate of return.
INTERNAL RATE OF RETURN (IRR)

The IRR of an investment or project is the “annualized effective compounded

return rate” or rate return that sets the net present value (NPV) of all cash flows
(both positive and negative) from the investment equal to zero. Equivalently, it is
the interest rate at which the net present value of the future cash flows is equal to
the initial investment and it is also the interest rate at which the total present value
of costs ( negative cash flow) equals the total present value of the benefits (positive
cash flows)

IRR represents the return on investment achieved when a project reaches its
breakeven point, meaning that the project reaches its breakeven point, meaning that
the project is only marginally justified as valuable. Given a collection of pairs
(time, cash flow) representing a project, the NPV is a function of the rate of return.
The internal rate of return is a rate for which this function is zero.

NPV=∑─Cn/ (1+r) n=0

This rational polynomial can be converted to an ordinary polynomial having the

same roots by substituting g (gain) for 1+r and multiplying by gn to yield the
equivalent but simpler condition.