Initial Cash Investment
The initial cash investment is the amount that the investor must pay the
seller for the right to receive future cash flows from the investment.
It includes loan points and fees, and sometimes improvements and repairs
to the property that cannot be financed.
A Simple Discounted Cash Flow Analysis  Finding the Present Value of an
Investment
Assume that the investor acquires an investment for cash, and that he requires
a 10% yield on his investment each year. Further assume that he will
hold the investment for one year. What should he pay to acquire the
investment?
The following statements are analogous:
 The investor wants to receive a 10% yield on his investment each year.
 The investor wants the annual rate of return on his investment to equal 10%.
 The investor wants the Annual Percentage Rate on his investment to equal 10%.
 The investor wants the Internal Rate of Return on his investment to equal 10%.
 The investor's discount rate is 10%.
To find the
amount that he should pay (the present value), the investor estimates the cash
flows to be received over the holding period, and then he "discounts"
these cash flows using the 10% discount rate.
We will assume a net income of $10,000.00.
Calculation of Net Cash Flows
Net Income 
$10,000 
Reversion (sale of investment) 
$100,000 
Total Cash Flow 
$110,000 




Discounting the Net Cash Flows
To discount the net cash flows shown above, we first calculate the "discount
factor," based upon our discount rate of 10%.
The formula for calculating this factor:
1 / (1+discount rate) ^ period
= discount factor
or
1 / (1.10) ^ 1 = .909090909
where the discount rate is 10% and period equals 1
Multiplying this one year discount factor by the net
cash flow results in a present value for the investment of $100,000.00.
Net Cash Flow 

Present Value Discount Factor 

Value 
$110,000 
divided by 
.909090909 
equals 
$100,000 
The goal of a discounted cash flow analysis is to determine what value
(there is only one) will produce the cash flows that satisfy the market
criteria set out in the analysis. With regards to real estate, these market
criteria often involve a mortgage loan. The Net Cash Flow example above
of $110,000 is also often referred to as "Net Income". Since
there is no loan involved in our example, Net Cash Flow and Net Income
are synonomous. But if a mortgage loan is a part of the transaction, Net
Income and Net Cash Flow are NOT synonomous. In a Discounted Cash Flow
Analysis, we always must discount the Net Cash Flow, not the Net Income.
Below, we provide an example of a Discounted Cash Flow Analysis when a
loan is involved.
Discounted Cash Flow Analysis  with a Mortgage Loan
In the example above, we knew the Net Cash Flows and we knew the discount
rate. But in more complex analyses, net cash flows are dependent
upon the initial cost of the investment. If, for example, some of
the funds will be borrowed, the loan amount and the repayments of that
loan will be dependent upon the initial cost of the investment. Thus,
to project the net cash flows, we must first establish the cost of the
investment. When we do this, the unknown becomes the discount rate
or Internal Rate of Return (these two terms are synonymous as used here),
and our problem becomes finding the Internal Rate of Return that will satisfy
the investor's requirements and also cover the mortgage loan payments.
To illustrate, assume that a particular investment will be acquired, using
50% borrowed funds and 50% cash equity; and further that the purchase price
is $90,909.10 (this odd purchase price will facilitate our example).
The cost of the borrowed money is 12%, payments are interest only, and
the holding period for the investment is one year.
The process of finding the Internal Rate of Return is called interation;
i.e. we must find a discount rate (or IRR) to apply to the net cash flows
whose result is equal to the present value of the initial cash investment
(already known). This is a trial and error method that would take
considerable time if done by hand. Fortunately, the computer is able
to make these calculations very quickly. The result is shown below.
Calculation of Net Cash Flow
Sale proceeds upon liquidation 
$90,909.10 
Net Income 
$10,000 
Interest Paid (90,909.10 / 2 x .12 
5,454.55 
Loan repayment 
45,454.55 
Net Cash Flow 
$50,000 
Calculation of the Present Value Discount Factor for one year at 10%


1/(1+discount rate) ^ period 
= 
Discount Factor 


1/(1.10) ^ 1 
equals 
.9090909 
Present Value of Net Cash Flows
Net Cash Flow 

Present Value Discount Factor
APR
IRR
Equity Yield Rate


Value of Initial Investment 
$50,000 
divided by 
.909090909 
equals 
$45,454.55 
As you can see, using an IRR (or discount rate) of 10%,
the present value of the net cash flows is equal to the initial investment of
$45,454.55. The present value of the initial loan amount must be added to the present
value of the initial investment in order to determine the value of the
property.