If someone promises to give you a series of payments in the future, you need some way to judge how much such an offer is worth. The discounted cash flow method is one way to decide on the value. To calculate the present value of a set of future payments, you simply bring back each future payment into the present time and add the present values together. When bringing the future payments back to the present, you must decide on a discount rate to apply. Choosing the discount rate can be fairly complicated, but essentially, you can consider it to be the best rate of return you could achieve by choosing an alternate investment or project with a similar level of risk.
Let's assume that you have selected a discount rate of 10% and someone offers to pay you $1000 at the end of the year for each of the next four years. The first payment occurs a year from now, so that has to be brought back one year. The second payment occurs two years from now, so that must be brought back two years. And, so forth for the third and fourth years.
PV = |
1000 (1.1)^{1} |
+ |
1000 (1.1)^{2} |
+ |
1000 (1.1)^{3} |
+ |
1000 (1.1)^{4} |
PV = $3,169.87 |
In this case, you would be willing to pay up to $3,169.87 for such a series of payments.
Net Present Value (NPV) is another important concept. NPV is the present value of a series of cash flows including all incoming and outgoing cash flows. If the calculated NPV is greater than 0, it means the project or investment meets the minimum level of returns indicated by the discount rate.
Going back the prior example, let's assume someone offered to sell you the four $1000 payments for $3500. If your discount rate is still 10%, the NPV can be calculated as follows:
NPV = | -3500 + |
1000 (1.1)^{1} |
+ |
1000 (1.1)^{2} |
+ |
1000 (1.1)^{3} |
+ |
1000 (1.1)^{4} |
NPV = -330.13 |
Since the NPV is less than 0, you would not accept this offer since it does not meet your required rate of return.