Introduction
A business, despite having all the capital and audience, must need to be secured from all ends to prevent any potential downfall. There are many techniques to estimate whether a business or an investment can reap profits over the years. While manual techniques might be difficult to operate with, there is certain software that performs similar functions with higher accuracy.
Two of these concepts are Discounted Cash Flow(DCF) and Net Present Value(NPV). Even though both these metrics help evaluate the profitability of an investment, they have different formulas and different applications.
NPV vs DCF
The main difference between NPV and DCF lies in their definition and formula. The Net Present Value(NPV) calculates the difference between the present values of cash inflows and cash outflows over some time. In contrast, Discounted Cash Flow(DCF) helps evaluate an investment based on the future cash influx expected. Thus, an NPV is a solid metric used to estimate a project's profitability. On the other hand, DCF answers more of a general question as to how much of a cash inflow can be expected through an investment.
Difference Between NPV and DCF in Tabular Form
Parameters of Comparison | NPV | DCF |
Definition | NPV can be described as the difference between the current value of the cash outflow and the current value of the cash inflow | DCF can be defined as the amount of cash inflow that can be expected in the future from an investment. |
Terminology | NPV stands for Net Present Value. | DCF stands for Discounted Cash Flow. |
Concept | NPV can be described as the result of the analysis. | DCF can be described as the analysis tool for calculating NPV. |
Comparisons | NPV evaluates the value of the investments in the current phase. | DCF evaluates the performance of an investment in the future. |
Relevance to Investments | NPV helps determine the value of an asset in the future. | DCF helps calculate how much investment might be required to achieve the expected influx. |
Formula | NPV is calculated by subtracting the value of the initial investment from the total DCF. | DCF is calculated through the summation of all the cash influxes in a given period. |
Scope | NPV requires the value of DCF to be calculated. | DCF does not include NPV in the formula but only adds up all the cash inflow. |
What is NPV?
Net Present Value(NPV) is a budgeting tool that helps measure the performance of an investment or a project based on the number of cash outflows and cash inflows. This concept is used widely in the industry of finance and real estate. Let us look at a few important points to note when discussing Net Present Value:-
- NPV is estimated by calculating the difference between the current value of cash inflows and the current value of cash outflows.
- Depending on the value of the resultant NPV, we figure out whether a project or an investment will reap profits overtime or not.
- NPV also relies on the value of DCF or discount rate as NPV tries to evaluate the worth of an investment based on future predictions.
- This is because the value of a dollar might not be the same as the value of the dollar at some point in the future. It can either lose value due to inflation or gain value due to good economical conditions. In such conditions, investing the same dollar might reap benefits at some point in the future.
- Thus, an NPV helps calculate the current value of an investment’s future cash flows based on the initial investment made.
Formula for Net Present Value(NPV)
As previously mentioned, NPV is calculated by subtracting the value of the initial investment from the value of the discounted rate, all considering the present values of the asset.
NPV=C1(1+r)1+C2(1+r)2+C3(1+r)3+....+Cn(1+r)n-(Initial Investment)
Where C1= Cash flow in the first period
C2= Cash flow in the second period
C3= Cash flow in the third period
r = Discount rate
The formula can also be written as NPV= n=0NCn(1+r)n
Where n= any period between the range of 0 to N
N= the total number of periods considered in the calculation
C= cash flow in the particular period n
r = Discount rate
Interpretation of the Formula and Result
When the value of NPV is calculated, there are three categories that the resultant value can fall into Positive NPV, Negative NPV, Zero NPV
Positive NPV: When the resultant value of an NPV is positive, it depicts that the value of an asset is worth more than the initial costs.
Negative NPV: When the resultant value of an NPV is negative, it depicts that the value of an asset is worth less than the initial costs.
Zero NPV: If the value of NPV is zero, then the asset is worth exactly the initial costs.
Decision rules of an NPV
The decision rule of an NPV is very simple since there are only three categories that it can be allotted into.
- If the resultant NPV is positive, the proposed project or investment can be accepted since it will turn out to be profitable.
- If the resultant NPV is negative, the proposed project or investment must be rejected since it cannot reap any profits.
- If the resultant NPV is zero, the proposed project or investment can either be accepted or rejected since the concept of NPV will not affect the decision-making process. It stays indifferent and thus can be called some sort of a break-even point.
Advantages of Calculating Net Present Value(NPV)
- Investment value: NPV doesn’t only evaluate whether a project turns out to be profitable but also provides us with the exact value of profits that it can reap.
- Time value of money: NPV is a budgeting tool that helps one analyze the profitability of a project by considering the time value of money. Time value of money comes into the view when the value of cash acquired might not have the same value in the future. Thus, by including this feature, we attempt to make a more accurate decision.
- Highly extensive: NPV proves to be a comprehensive tool since it takes into consideration all sorts of factors such as risks, discount rates, inflows & outflows when compared to other analysis tools
Disadvantages/Limitations of Calculating Net Present Value(NPV)
- Extra calculation:- One of the main disadvantages while calculating NPV is the determination of discounted rate. When the discount rate is assumed to be high, it might result in a negative value of NPV that is not true. Similarly, if we assume a low discount rate, we might acquire a high NPV value that might also be wrong.
- Too many assumptions: While this method might be very widely used in the finance industry, there are a lot of assumptions made while creating the formula for the same. Besides the unpredictable expenditures that might arise after the project starts, there is also the possibility that the influx of cash can differ at any point in time.
- Limited scope: The concept of NPV can only be used to compare projects if they belong to the same period. This is a very common FAQ since most companies or interested investors plan on comparing two projects that they have in mind to make their decision. Thus, NPV cannot typically be used to compare two assets but only evaluate them individually.
What is DCF?
Discounted Cash Flow(DCF) is a similar method of evaluation that helps us determine the worth of an investment or a project, based solely on the expected cash flows in the future. Since it is a little tricky to understand the factor of time, let us explain it this way: The concept of DCF helps estimate the value of a project in the present day based on the profitability it will bring in the future. Let us look at some important points to note regarding Discounted Cash Flow:-
- The future cash influx expected is calculated by using the value of the discount rate.
- Few investors employ the usage of Weighted Average Cost of Capital(WACC) instead of discount rate since it also considers the rate of return that most investors or shareholders expect.
- The concept of DCF also includes the factor of the time value of money. As previously mentioned, the money acquired presently may or may not be worth the same in the future and this will change the predictions accordingly.
- Since both these methods depend on several assumptions, any kind of the slightest change will affect the overall result of the analysis.
- Despite being a widely used technique in predicting profitability, we must always benchmark it against legitimate market valuation tools.
Formula for Discounted Cash Flow(DCF)
The value of DCF is calculated by summing all the cash inflows, each individually divided by the discount rate raised to the power of the period number it was calculated in.
NPV=C1(1+r)1+C2(1+r)2+C3(1+r)3+....+Cn(1+r)n
Where C1= Cash flow in the first period
C2= Cash flow in the second period
C3= Cash flow in the third period
r = Discount rate
A DCF can also help us estimate the worth of bonds, shares, properties that are rented, cost-friendly initiative, start-ups, and other new businesses.
Advantages of Calculating Discounted Cash Flow
- Based on cash flow: The concept of DCF focuses more on the cash inflows rather than the earnings alone. This means any kind of cash input will be considered and it does not have to be just earnings.
- Better comprehension: The calculations and estimation of DCF requires a full understanding of the key concepts of business and thus, helping the investors completely understand the market.
- NPV: When calculating DCF, we also provide material to calculate the value of NPV since we only need to subtract the value of the initial investment from DCF to acquire NPV.
Disadvantages of Calculating Discounted Cash Flow
- Multiple assumptions: Similar to the calculation of NPV, there are several assumptions made while calculating DCF. When subjected to the slightest variation, the outcome can switch and change completely.
- Time-consuming: it can take quite some time to build depending upon the amount of detail and the period considered for the certain investment.
Main Differences Between NPV and DCF In Points
- NPV and DCF are very closely related but differ right until their fundamental concept. DCF calculates the amount of cash inflow that a particular investment can bring whereas NPV can be described as the difference in the current values of cash inflows and cash outflows.
- The full form of NPV is Net Present Value whereas the full form of DCF is Discounted Cash Flow.
- While describing this process of analyzing an investment in simpler terms, we can describe NPV as the result of the analysis whereas DCF is the tool used in the analysis.
- When talking specifically in relevance to assets or investments, NPV evaluates how an asset can perform in the future whereas DCF can also determine how much of an investment is needed to acquire the desired amount of cash influx.
- When comparing the components needed for calculating both these elements, we evaluate the performance of NPV in the present phase whereas DCF evaluates the value of an investment in the future.
- When talking in terms of the formula, NPV is calculated by subtracting the value of DCF from the initial investment made. On the other hand, the value of DCF is calculated by the summation of all the cash inflows that a particular investment can make.
- NPV requires the value of DCf to calculate whereas DCF does not require the value of NPV to be calculated. DCF only adds all the cash inflows an investment can acquire.
Conclusion
Summarizing the above discussion, we can state that DCF calculates the cash flows to predict the worth of the investment whereas NPV calculates the difference between the cash inflows and cash outflows to estimate the benefits that an investment will reap based on the present values.
References
- https://www.wallstreetprep.com/knowledge/npv-net-present-value/
- https://groww.in/p/discounted-cash-flow