CHAPTER 22
Calculation 16: Discounted Cash Flow
What It Means
In a previous chapter, you saw how to find the present value of a single future cash flow. Doing so allowed you to know the worth of that cash flow in current dollars.
The typical investment property generates more than one cash flow over time. You hope that it will generate positive cash from operations each year, and you certainly expect to end up with cash to take home from the eventual sale of the property. You consider these sale proceeds to be a cash flow also.
Collectively, your investment’s cash flows represent its entire income stream. When you discount each of these cash flows back to its present value and then add those PVs up, the sum represents the present value of the entire income stream. We call this process of finding the present worth of the whole income stream discounted cash flow.
Why do you discount the cash flows individually instead of as a lump sum? As you’ve seen many times in our earlier discussions, the answer lies in the time value of money. These cash flows occur at different times. The longer you have to wait for a particular return, the more severely it has to be discounted and the less it is worth. A dollar received in 10 years is far less valuable than a dollar received in one year. You find the PV of each cash flow according to the length of time you must wait for it.
How to Calculate
Once again you can use a simple Excel template provided at http://www.realdata.com/book, where you just fill in the cash flows and the discount rate and Excel calculates the present value of each cash flow and displays the total:
Earlier you saw how to calculate PV using the “Annual Present Value Factors” table. To calculate the discounted cash flow, you just compute several PVs and add them up. You use the table to complete the examples here. You can also use the following form to facilitate your calculations:
Example
You operate a property and forecast that you will have the following cash flows:
You also estimate that the sale of your property five years from now will produce cash proceeds of $200,000. If you discount these cash flows at 10.5% per year, what is the present value of the entire income stream?
Start by entering the cash flows into the following form. Note that your cash flow for year 5 includes both the cash from operation and the cash from resale of the property:
Go to the table and look up the factor where the column for 10.5% intersects the row for year 1. You should find 0.9049771. Do the same for years 2 through 5 and fill in the PV factors on the form:
Finally, multiply each cash flow by its factor to find its present value and then total all the PVs (Figure 22.4). Round your total to the nearest dollar:
Test Your Understanding
You operate a property and forecast that you will have the following cash flows:
You also estimate that you will sell the property at the end of year 7 for $750,000. You expect your costs of sale to be 7%. At the time of sale, your mortgage will have an unpaid balance of $395,000. If you discount all cash flows at 10.0% per year, what is the present value of the entire income stream?
Answer
Before you can plug all the cash flows into the form, you need to calculate your final cash flow, the proceeds of sale. Recall the formula from the chapter on this subject:
less Costs of Sale
less Mortgage Payoff
= Sale Proceeds Before Taxes
Your costs of sale are 7% of the selling price, or $52,500.
You need to make one more calculation before you use the DCF form. The cash flow for year 7 is the combination of the cash flow from operation and the sale proceeds. Hence, the total cash flow for that year equals $8,350 plus $302,500, or $310,850.
Now on to the last form. Enter the cash flows; look up and enter the PV factors at 10.0% for years 1 through 7; multiply each cash flow by its factor; and, finally, add up the PVs to get the discounted cash flow of the entire income stream:
