Your small business is growing and you have the opportunity to make an investment in your business. The investment will cost you $30,000 and is estimated to generate $6,000 a year for the next five years. Should you do it?
At first glance, an investment opportunity generating $6,000 a year can seem attractive to you. But $6,000 a year from now isn’t worth as much as $6,000 today.
Discounting cash flows can help you make an informed investment decision and better understand what the projected income is worth in present time.
The Time Value of Money
The money you have on hand today is worth more than the same amount of money in the future. The dollar you have in your wallet today has more buying power than a dollar a year from now. That’s because of different factors, like the effect of rising inflation.
The time value of money is the reason why you discount cash flows. In the example investment opportunity above, the buying power of the $6,000 generated in each year decreases as time goes on. To find out if the project is a good investment opportunity, you would discount the future cash flows to find the present value of the money. Simply put, you’re finding out how much $6,000 a year from now is worth in today’s time.
What Is a Discount Rate?
To discount projected cash flows, you use a discount rate. The discount rate is used for two reasons: It tells you the required rate of return on your investment and it takes into consideration the amount of risk involved with the investment.
The $30,000 you have on hand right now doesn’t change. You have that money to do what you want with it, such as putting it in a savings account to collect interest. By using the money to make an investment, there’s no guarantee the project will generate the money estimated. In the example above, it’s estimated the investment will generate $6,000 a year for five years, but that could change and you may get less money. That’s the risk involved in investing.
When you choose a discount rate, it also represents the required rate of return for your investment. There’s no definitive discount rate that you should use; it’s dependent on your investment situation. Generally speaking, a higher discount rate represents higher risk and a lower rate represents lower risk. Some may use a lower single-digit discount rate and others may use a discount rate of 10%.
A good rule of thumb to follow is to use the federal funds rate as your discount rate. This is because if you were to put your money in a savings account, it would grow at the given interest rate. By using the federal funds rate as your discount rate, you’re essentially saying that this is your required rate of return for investing.
How Do You Discount Cash Flows?
When you know the projected cash flows for an investment, you can use a formula to discount them. Here’s the formula:
(Cash flow for the n year / (1+r)n)
In this formula, r represents the discount rate. The n represents the year of the projected cash flow. If the investment you’re looking at includes projected cash flows over a number of years, you can use the formula above to discount them.
Using the example above, let’s say the discount rate is the federal funds rate of 2.25%. To discount the cash flows from the example above, plug the numbers into the formula:
($6,000/(1+.0225)1) = $5,867.97
($6,000/(1+.0225)2) = $5,738.85
($6,000/(1+.0225)4) = $5,489.06
($6,000/(1+.0225)5) = $5,368.27
When you get the results, you’ll see that the $6,000 the project is generating each year in the future isn’t worth the same amount in today’s time. And, as time goes on, the $6,000 loses more and more buying power. This is important information to have because it gives you a better idea of how much money you may actually be getting back in return.
To help you make a more informed decision on whether to pursue the investment, you can use the Discounted Cash Flow analysis. This requires adding up the discounted cash flows. The sum represents the value of the investment. In the above example, the investment is worth $28,076.71. With an initial cost of $30,000, this may not be a good investment opportunity. That’s because you may see a lower rate of return than the 2.25% discount rate used since the sum of the discounted cash flows is lower than the initial investment. If the sum was higher, you could see a higher return.
Be aware that discounting cash flows and the formula are largely dependent on assumptions and estimations. This means that changing the value of any element of the formula could significantly change the results. For example, if you use a different discount rate than 2.25%, you will get a higher or lower result.
When you’re discounting cash flows, it’s best to use the most accurate information you can. Try not to be overly optimistic about the potential cash an investment project can generate in the future. When in doubt, stay conservative with your estimates.
Another Discounted Cash Flow Example
Whether you’re the owner of a construction company looking to invest in another company to expand, or you’re a restaurateur looking to purchase a new piece of equipment, discounting cash flows can be a helpful way for you to determine if it makes sense to make the investment.
If you’re looking to purchase a piece of equipment that costs $20,000 and will generate $7,000 over the next four years, you can discount the cash flows to figure out how much that money is worth in present time. In this example, we’ll use a discount rate of 5%.
|($7,000 / (1+.05)1)||$6,666.67|
|($7,000 / (1+.05)2)||$6,349.21|
|($7,000 / (1+.05)3)||$6,046.86|
|($7,000 / (1+.05)4)||$5,758.92|
This shows you that while the piece of equipment is estimated to generate $7,000 in the first year, that money is worth about $6,666.67 today.
Adding the discounted cash flows gives you a total return of about $24,821.66. This is more than the $20,000 it would cost to invest, which means the equipment may give you a good return on your investment.
As more time goes on, the same amount of money loses its buying power. Because of this, it’s important to know how to discount the projected cash flows of a project. By doing this, you’ll have a better understanding of how much the money an investment is generating is worth in present time. This can help you make a more informed decision about the investment opportunity.
As a small business owner, you’re an expert, too. We want to hear about how you feel about discounted cash flow. Let us—and your fellow SBOs—know by sharing a comment below.