How to Create a Discounted Cash Flow – DCF | Video

The Discounted Cash Flow is a way to model flows of money into and out of a business, operation, or project, that takes account of the effects of interest and inflation. Money spent or earned today has a different value to money spent or earned in the future.

But, how do we create a Discounted Cash Flow? I’ll show you.

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Explaining How to Create a Discounted Cash Flow in Three Steps

Shortly after the start of my Project Management career, I needed to create Discounted Cash Flows for large, multi-year projects. In this video, I hit the spreadsheet again, and show you how I did it.

Discounted Cash Flow Step 1

In the video, this is our first table.

• Start with Year indices.
  Now = Year 0
  Put in $100 income in year 0
• What’s it worth in future years?
  Let’s have an interest rate of i=5%
• We can calculate the interest payments in years 1 to 5.
  At the end of year 1, our $100 is worth $105
• But we also have inflation.
  Assume an inflation rate of k=1.5%
  We can calculate the effect of inflation in each year with k[n+1]=(1+k[n])x(1+k)-1
  This means, that, at the end of year 1, our $100 is really worth $103.45 in today’s money
  We call this the Present Value (PV) of the $105
• We can use a single figure to represent the effect of interest rate i and inflation rate k.
  This is the Real Interest Rate, R=3.45%
  We can calculate R: 1 + R = (1 + i) / (1 + k)
  R = (1 + i) / (1 + k) – 1
• Simplify to create a Discount Rate.
  However, we typically simplify this by saying that the real interest rate is approximately i – k
  We call this the Discount Rate, r:  r = i – k

Discounted Cash Flow Step 2

In the video, this is second first table.

• Next, we create a series of payments in years 1 to 5.
  We often label these with the letters PMT, meaning ‘payment‘.
• Discount Factor.
  We can calculate a PV factor for each of these, that will convert each to a Present Value
  The PV factor (or Discount Factor), D[n] is:
  D[n] = 1 / ( 1+r )^n
• So, the present value PV of a payment PMT is:
  PV = PMT * D[n]
  The flow of Present Values is the Discounted Cash Flow (DCF)
• If we add up all of the Present Values in the DCF, we get a total called the Net Present Value, NPV

Discounted Cash Flow Step 3

In the video, this is our third table.

• Now we re-build the table to show cash outflows (or costs) as negative, and cash inflows (benefits) as positive.
• Let’s have a look at the NPV now.
  If this is positive, we have a net benefit, if it is negative, we have a net cost. If it is precisely zero, this is a break-even project
• Next, we can ask ‘What discount rate would render the NPV to be exactly zero?’
  This special Discount Rate is called the Internal Rate of Return, IRR.
  This is the equivalent interest rate received for an investment equal to the payments (negative values) that gives this income (positive values).
  So, if your project has a higher IRR than an alternative investment, then it offers a better value use of your money, resources, and time.

Discounted Cash Flow – Bonus Step

• In Table 2, the Equivalent Annual Cost over 5 years (A[5]) of $451.51 is $100
  A single payment (P), say of $445.18, in year zero is equivalent to n (=5) annual payments in years 1 to n of, in this case $100.00.
  A[n] = P x r / ( 1-D[n] )
  So, the Equivalent Annual Factor a[n] is:
  a[n] = r / ( 1-D[n] )
  So, A[n] = P x a[n]

Summing-up: DCF and Project Management

A Discounted Cash Flow is a powerful tool for modeling and measuring the value of a project. It requires some facility with basic math, and a familiarity with spreadsheets. But, it is something any Project Manager should be capable of creating and evaluating. Just take some time to learn and understand the principles, and you are all set.

Recommended Videos to Help with Project Value, Business Case, and Discounted Cash Flow

Carefully curated video recommendations for you:

• What is a Discounted Cash Flow – DCF? | Video
• What is a Business Case? | Video
• Project Business Case: Write an Effective Project Proposal | Video
• How to Estimate Project Costs | Video
• How to Deliver Effective Project Cost Management | Video
• Pressure to Reduce Your Project Budget | Video
• How to Anticipate Future Budget Challenges to Your Project | Video
• What is Value? …or Project Value? | Video
• What are Project Benefits? | Video

Recommended Articles to Help with Project Value, Business Case, and Discounted Cash Flow

• Project Business Case: How to Create the Perfect Project Proposal
• Project Cost Management: What You Need to Know and Do
• 3 Ways to Produce Your Next Project Budget
• Value Delivery: The Driving Force that should Motivate your Projects
• Benefits Management: What Every Project Manager Needs to Know [and Do]

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