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The Discounted Cash Flow Method involves estimating net cash flows over
the period of investment (Holding Period), and then calculating the present
value of that series of cash flows by discounting those net cash flows
using a selected "discount rate." Conversely, if the discount
rate is unknown, but the initial investment is known, we can calculate
the discount rate.
|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
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|
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.
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