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How to Create a Discounted Cash Flow – DCF | Video

How to Create a Discounted Cash Flow - DCF

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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This is learning, so, sit back and enjoy

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.

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About the Author Mike Clayton

Dr Mike Clayton is one of the most successful and in-demand project management trainers in the UK. He is author of 14 best-selling books, including four about project management. He is also a prolific blogger and contributor to and Project, the journal of the Association for Project Management. Between 1990 and 2002, Mike was a successful project manager, leading large project teams and delivering complex projects. In 2016, Mike launched OnlinePMCourses.

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