Page 4: Discounted cash flow
A business must consider whether the value of investing in a particular project will be greater than the value it might lose from not investing in other projects. This is known as opportunity cost.
Discounted cash flow helps a business consider what the value of money likely to be received in the future is worth today. It takes into account the effect of time on an investment. It also shows how interest rates affect the present value of future revenues.
For example, if a business places £100 in a savings account with 10% interest it will grow to be worth £110 in a year's time. Put another way, £110 in a year's time is worth £100 today. By a similar calculation, £100 in a year's time is worth £90.90 (100 x 100/110) today. This is its present value.
- At a 10% discount rate, the discount factor for year 1 is 0.909.
- At a 10% discount rate, £100 in two years' time has a present value of 100 x (100/110)2 = £82.60. The discount factor for year 2 is 0.826.
- Future years discount factors are calculated in the same way.
The net present value (NPV) shows the return on investment less the costs of the project. This would help McCain decide whether each project is worth investing in.
Net present value at 10% discount rate
This shows NPV on both projects is identical and profitable after discounting the expected cash flows. However, a business will take other important factors into consideration when planning a project, for example, the value of social or environmental impacts.
Internal rate of return
Internal rate of return (IRR) also uses discounted cash flow. A business must find the rate of return where the NPV is zero. This is compared to the market interest rate to assess if the investment will give a better return than, for example, investing in a bank.
The IRR is usually calculated by computer. However, an approximation can be found using trial and error. For example, if a discount rate of 12% is applied to the net present value of the wind turbine project, the NPV is only just positive. This means that the IRR must be just over 12%.
Net present value of the turbines project, 12% discount rate
The evidence of all the calculations shows that McCain should continue with the projects. However, there are still risks in the projects. If McCain has estimated the future prices of energy as higher than they will be or if the costs of the project increase, savings will be less than expected.