Time value of money is a vital concept in investments that takes into account the reduction in real value of funds due to the effects of inflation. The key difference between discounted and undiscounted cash flows is that discounted cash flows are cash flows adjusted to incorporate the time value of money whereas undiscounted cash flows are not adjusted to incorporate the time value of money. The outcome of an evaluation of an investment project using these two methods will be significantly different, thus it is important to clearly distinguish between the two.
CONTENTS
1. Overview and Key Difference
2. What are Discounted Cash Flows
3. What are Undiscounted Cash Flows
4. Side by Side Comparison – Discounted vs Undiscounted Cash Flows
5. Summary
What is Discounted Cash Flow?
Discounted cash flows are cash flows adjusted to incorporate the time value of money. Cash flows are discounted using a discount rate to arrive at a present value estimate, which is used to evaluate the potential for investment. Discounted cash flows are calculated as,
Discounted cash flows= CF 1/ (1+r) 1 + CF 2/ (1+r) 2 +… CF n (1+r) n
CF= Cash flow
r = Discount rate
Discounted cash flows can be easily calculated by the above formula if there are limited cash flows. However, this formula is not convenient to be used in discounting many cash flows. In that case, discounting factors can be easily acquired through the present value table that shows the discounting factor with correspondence to the number of years. Discounted cash flows can be used to evaluate investment decisions by comparing the discounted cash inflows and cash outflows. Net Present Value (NPV) is an investment appraisal technique that uses discounted cash flows to arrive at the financial viability of a project.
E.g. XYZ Ltd is planning to make an investment in a new factory in order to increase production. Consider the following information.
- The investment project will span over a period of 4 years
- Initial investment is $17,500m which will be invested in Year 0 (today)
- The investment has a residual value of $5,000m
- Cash inflows and outflows will happen from Year 1 to Year 4
- Cash flows will be discounted using a discount rate of 8%
The above project results in a negative NPV of $522.1m, and XYZ should reject the project. Since the cash flows are discounted this means that if the project is accepted the total net outcome will be ($522.1m) in today’s terms.
Figure 1: NPV calculation uses discounted cash flows
What is Undiscounted Cash Flow?
Undiscounted cash flows are the cash flows not adjusted to incorporate the time value of money. This is the opposite of discounted cash flows and merely consider the nominal value of cash flows in making investment decisions. Since undiscounted cash flows do not consider the reduction in value of money over time, they do not assist accurate investment decisions. Considering the same example as above, NPV is calculated without discounting the cash flows.
Example
With undiscounted cash flows the project generates a positive NPV of $3,640m. However, at the end of a 4 year period, $3,640 will not be generated due to the effect of time value of money; hence this NPV is heavily overstated.
What is the difference Discounted and Undiscounted Cash Flows?
Discounted vs Undiscounted Cash Flows |
|
| Discounted cash flows are cash flows adjusted to incorporate the time value of money | Undiscounted cash flows are not adjusted to incorporate the time value of money. |
| Time Value of Money | |
| Time value of money is considered in discounted cash flows and thus are highly accurate. | Undiscounted cash flows do not account for time value of money and are less accurate. |
| Use in Investment Appraisal | |
| Discounted cash flows are used in investment appraisal techniques such as NPV | Undiscounted cash flows are not used in investment appraisal. |
Summary – Discounted vs Undiscounted Cash Flows
The difference between discounted and undiscounted cash flows depends on the use of discounted or nominal cash flows. As reflected in the above examples, the resulting NPV of the same project is significantly different using discounted and undiscounted cash flows. Thus, the use of undiscounted cash flows is considered a risky approach in assessing the viability of an investment decision. For this reason, many businesses use discounted cash flows to consider whether a selected project will generate favorable returns or not.
References
1.”Discounted Cash Flow (DCF).” Investopedia. N.p., 29 Sept. 2015. Web. 07 Apr. 2017.
2. Jan, Irfanullah. “Net Present Value (NPV).” Net Present Value (NPV) Definition | Calculation | Examples. N.p., n.d. Web. 07 Apr. 2017.
3. “Undiscounted Future Cash Flows.” AccountingTools. N.p., n.d. Web. 07 Apr. 2017.