DCF/NPV (Blog 2)
I will go into DCF/NPV and how it works.
I am assuming the average joe has no clue what either are since it is only relevant to me because I’m going into the financial services industry. The author does a good job explaining how a DCF/NPV model can be detrimental to Innovation, but he does not go into depth about what it is so I will in this blog.
DCF stands for Discounted Cash Flow and NPV is Net Present Value. It is used to figure out the value of an investment today, based on projections of how much money it will generate in the future, usually based off of 5-year predictions. It can be used to decide on projects or other opportunities for a company to innovate.
The key to DCF/NPV is understanding the basic finance concept of the time value of money which means that a dollar today is worth more than a dollar tomorrow. This is true because one can invest that dollar today and have a return by tomorrow.
The next steps is understanding what a basic cash flow is. A cash flow is the amount of money being transferred in or out of a business. It can be negative if more is spent than made in a given year or positive if you make a profit. It’s calculated by subtractive benefit and cost. (Revert to example below)
Next, you must discount these future cash flows to present value figures by multiplying all future cash flows by its discount factor. We won’t get into the intricacies of how to discount because that can be tricky, but each year’s discount factor is given in the example below.
Once you solve for each year’s discounted cash flow, you add them all together to get the NPV.
- NPV = -100,000 + 14,145 + 22,250 + 29,400 + 27,720 = -6,485.
Since the NPV is negative, this means you should not pursue this business venture. A positive NPV “theoretically” means the opportunity is profitable and you should do it.