Skip to main content
SpringerLink
Log in

Discounted Cash Flow Methods

  • Chapter
  • First Online:
Investment Appraisal

Part of the book series: Springer Texts in Business and Economics ((STBE))

Abstract

The discounted cash flow methods described in this chapter are classified as ‘dynamic’ investment appraisal methods, which, unlike the static methods described in Chap. 2, explicitly consider more than one time period and acknowledge the time value of money. Investment projects can be described as streams of (expected) cash inflows and outflows over the whole course of their economic life, i.e. over different time periods. Methods described and discussed in this chapter are the net present value method, the annuity method, the internal rate of return method and the dynamic payback period method. All of them are subject to a set of assumptions that are also discussed in this part.

This is a preview of subscription content, log in via an institution to check access.

Access this chapter

Log in via an institution
Chapter
USD 29.95
Price excludes VAT (USA)
  • Available as PDF
  • Read on any device
  • Instant download
  • Own it forever
eBook
USD 84.99
Price excludes VAT (USA)
  • Available as EPUB and PDF
  • Read on any device
  • Instant download
  • Own it forever
Hardcover Book
USD 109.99
Price excludes VAT (USA)
  • Durable hardcover edition
  • Dispatched in 3 to 5 business days
  • Free shipping worldwide - see info

Tax calculation will be finalised at checkout

Purchases are for personal use only

Institutional subscriptions

References

  • Boulding, K. E. (1936). Time and investment. Economica, 3(12), 196–214.

    Article  Google Scholar 

  • Fisher, I. (1930). Theory of interest. New York: Macmillan.

    Google Scholar 

  • Lücke, W. (1955). Investitionsrechnungen auf der Grundlage von Ausgaben oder Kosten? Zeitschrift für handelswissenschaftliche Forschung, NF, 7, 310–324.

    Google Scholar 

  • Lücke, W. (1991). Investitionslexikon (2nd ed.). München: Vahlen.

    Google Scholar 

  • Preinreich, G. A. D. (1937). Valuation and amortization. The Accounting Review, 12(3), 209–226.

    Google Scholar 

Download references

Author information

Authors and Affiliations

  1. Faculty of Economics and Business Administration, Technische Universität Chemnitz, Chemnitz, Germany

    Uwe Götze

  2. Faculty of Business, The Auckland University of Technology, Auckland, New Zealand

    Deryl Northcott

  3. Faculty of Business and Economics, Schmalkalden University of Applied Sciences, Schmalkalden, Germany

    Peter Schuster

Authors
  1. Uwe Götze
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Deryl Northcott
    View author publications

    You can also search for this author in PubMed Google Scholar

  3. Peter Schuster
    View author publications

    You can also search for this author in PubMed Google Scholar

Appendices

Assessment Material

1.1 Exercise 3.1 (Net Present Value Method and Annuity Method)

The initial investment outlay of an investment project is €100,000. Use the following data:

  • Economic life: 5 years

  • Liquidation value: €10,000

Table 3.6 Cash inflows and outflows of the investment project
Full size table

Where:

  • CIFt = Current cash inflows in t

  • COFt = Current cash outflows in t

The uniform discount rate is 5 %. Is it a good idea to acquire this item? Ascertain:

  1. (a)

    The net present value.

  2. (b)

    Using a financing and redemption plan, the value that would arise if the item were to be wholly financed by internal funds.

  3. (c)

    The annuity.

1.2 Exercise 3.2 (Net Present Value Method and Internal Rate of Return Method)

A company has to decide between three investment projects. The characteristics of these are as follows:

Table 3.7 Characteristics of the three investment projects A, B, and C
Full size table

The economic life of all three projects is 5 years.

The uniform discount rate is 10 %.

  1. (a)

    Calculate the net present values of the investment projects and assess the relative profitability of each.

  2. (b)

    Calculate the projects’ internal rates of return.

1.3 Exercise 3.3 (Dynamic Investment Appraisal Methods)

To maintain production of an important product, a metal processing company is forced to replace a piece of equipment. As there is a good order book, an expansion of production could also follow from this investment. There are two investment projects to choose from with the following data (€):

Table 3.8 Data for the investment projects I and II
Full size table

The uniform discount rate is 6 %.

  1. (a)

    Assess the relative profitability of the two projects using

    1. (a1)

      The net present value method.

    2. (a2)

      The annuity method.

    3. (a3)

      The internal rate of return method.

    4. (a4)

      The dynamic payback period method.

  2. (b)

    What is the reason for possible different results while using the net present value method and the internal rate of return method?

  3. (c)

    Assess the premises and applicability of each method; in particular refer to the consideration of different initial investment outlays and economic lives. Which possibilities exist to balance these differences?

Further exercises will be included in the assessment material for Chaps. 4 and 5 in the context of advanced investment appraisal methods and applications.

Further Reading – Part II

  • Alesii, G. (2006). Payback period and internal rate of return in real options analysis. Engineering Economist, 51(3), 237–257.

  • Ang, J. S., Chua, J. H., & Sellers, R. (1979). Generating cash flow estimates: An actual study using the Delphi technique. Financial Management, 8(1), 64–67.

  • Baldwin, C. Y., & Ruback, R. S. (1986). Inflation, uncertainty, and investment. Journal of Finance, 41(3), 657–669.

  • Baron, D. P. (1979). Investment policy, optimality, and the mean-variance model. Journal of Finance, 34(1), 207–232.

  • Baumol, W. J., & Quandt, R. E. (1965). Investment and discount rates under capital rationing—A programming approach. Economic Journal, 75(298), 317–329.

  • Berkovitch, E., & Israel, R. (2004). Why the NPV criterion does not maximize NPV. Review of Financial Studies, 17(1), 239–255.

  • Block, S. (2005). Are there differences in capital budgeting procedures between industries? An empirical study. Engineering Economist, 50(1), 55–67.

  • Blohm, H., Lüder, K., & Schaefer, C. (2012). Investition: Schwachstellenanalyse des Investitionsbereichs und Investitionsrechnung (10th ed.). München: Vahlen.

  • Boulding, K. E. (1936). Time and Investment. Economica, 3(12), 196–214.

  • Boyle, G., & Guthrie, G. (2006). Payback without apology. Accounting & Finance, 46(1), 1–10.

  • Breuer, W. (2012). Investition I. Entscheidungen bei Sicherheit (4th ed.). Wiesbaden: Gabler.

  • Brown, R. J. (2006). Sins of the IRR. Journal of Real Estate Portfolio Management, 12(2), 195–199.

  • Burton, R. M., & Damon, W. W. (1974). On the existence of a cost of capital under pure capital rationing. Journal of Finance, 29(4), 1165–1173.

  • Cooper, W. D., Morgan, R. G., Redman, A., & Smith, M. (2001). Capital budgeting models: Theory vs. practice. Business Forum, 26(1/2), 15–19.

  • Doenges, R. C. (1972). The ‘reinvestment problem’ in a practical perspective. Financial Management, 1(1), 85–91.

  • Dorfman, R. (1981). The meaning of the internal rate of return. Journal of Finance, 36(5), 1011–1021.

  • Elton, E. J. (1970). Capital rationing and external discount rates. Journal of Finance, 25(3), 573–584.

  • Elton, E. J., & Gruber, M. J. (1971). Valuation and the cost of capital for regulated industries. Journal of Finance, 26(3), 661–670.

  • Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical work. Journal of Finance, 25(2), 383–417.

  • Fama, E. F., & French, K. R. (1999). The corporate cost of capital and the return on corporate investment. Journal of Finance, 54(6), 1939–1967.

  • Fama, E. F., & French, K. R. (2002). The equity premium. Journal of Finance, 57(2), 637–659.

  • Fama, E. F., & Gibbons, M. R. (1982). Inflation, real returns and capital investment. Journal of Monetary Economics, 9(3), 297–323.

  • Fama, E. F., & Laffer, A. B. (1971). Information on capital markets. Journal of Business, 44(3), 289–298.

  • Fisher, I. (1930). Theory of Interest. New York: Macmillan.

  • Franke, G., & Hax, H. (2009). Finanzwirtschaft des Unternehmens und Kapitalmarkt (6th ed.). Berlin: Springer.

  • Götze, U. (2014). Investitionsrechnung (7th ed.). Berlin, Heidelberg: Springer.

  • Hirshleifer, J. (1958). On the theory of optimal investment decision. Journal of Political Economy, 66(4), 329–352.

  • Hirshleifer, J. (1961). Risk, the discount rate, and investment decisions. American Economic Review, 51(2), 112–120.

  • Ingraham, H. G., Jr. (1979). An analysis of two cost comparison methods—Interest adjusted cost vs. Linton yield. CLU Journal, 33(4), 34–43.

  • Keane, S. M. (1979). The internal rate of return and the reinvestment fallacy. Abacus, 15(1), 48–55.

  • Keef, S. P., & Roush, M. L. (2001). Discounted cash flow methods and the fallacious reinvestment assumption: A review of recent texts. Accounting Education, 10(1), 105–116.

  • Kelleher, J. C., & MacCormack, J. J. (2005). Internal rate of return: A cautionary tale. McKinsey Quarterly 70–75

  • Kruschwitz, L. (2011). Investitionsrechnung (13th ed.). München: Oldenbourg.

  • Kruschwitz, L., & Loeffler, A. (2006). Discounted Cash Flow: A Theory of the Valuation of Firms. Chichester: Wiley.

  • Lewellen, W. G., Lanser, H. P., & McConnell, J. J. (1972). Payback substitutes for discounted cash flow. Financial Management, 8(2), 195–206.

  • Little, J. D. C. (2004). Models and managers: The concept of a decision calculus. Management Science, 50(12), 1841–1853.

  • Longbottom, D. A., & Wiper, L. (1977). Capital appraisal and the case for average rate of return. Journal of Business Finance and Accounting, 4(4), 419–426.

  • Longbottom, D. A., & Wiper, L. (1979). Capital appraisal and the case for average rate of return: A reply. Journal of Business Finance & Accounting, 6(2), 243–244.

  • Lücke, W. (1955). Investitionsrechnungen auf der Grundlage von Ausgaben oder Kosten? Zeitschrift für handelswissenschaftliche Forschung, NF, 7, 310–324.

  • Lücke, W. (1991). Investitionslexikon (2nd ed.). München: Vahlen.

  • Meyer, R. L. (1979). A note on capital budgeting techniques and the reinvestment rate. Journal of Finance, 34(5), 1251–1254.

  • Miller, M. H., & Modigliani, F. (1966). Some estimates of the cost of capital to the electric utility industry, 1954-57. American Economic Review, 56(3), 333–392.

  • Miller, M. H., & Modigliani, F. (1967). Some estimates of the cost of capital to the electric utility industry: 1954-57: Reply. American Economic Review, 57(5), 1288–1300.

  • Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. American Economic Review, 48(3), 261–297.

  • Modigliani, F., & Miller, M. H. (1959). The cost of capital, corporation finance, and the theory of investment: Reply. American Economic Review, 49(4), 655–669.

  • Modigliani, F., & Sutch, R. (1966). Innovations in interest rate policy. American Economic Review, 56(2), 178–197.

  • Modigliani, F., & Weingartner, H. M. (1958). Forecasting uses of anticipatory data on investment and sales. Quarterly Journal of Economics, 72(1), 23–54.

  • Nicol, D. J. (1981). A note on capital budgeting techniques and the reinvestment rate: Comment. Journal of Finance, 36(1), 193–195.

  • Perridon, L., Steiner, M., & Rathgeber, A. (2012). Finanzwirtschaft der Unternehmung (16th ed.). München: Vahlen.

  • Pogue, M. (2004). Investment appraisal: A new approach. Managerial Auditing Journal, 19(4), 565–569.

  • Pratt, J. W., & Hammond, J. S., III. (1979). Evaluating and comparing projects: Simple detection of false alarms. Journal of Finance, 34(5), 1231–1241.

  • Preinreich, G. A. D. (1937). Valuation and amortization. The Accounting Review, 12(3), 209–226.

  • Remer, D. S., & Nieto, A. P. (1995a). A compendium and comparison of 25 project evaluation techniques: Part 1: Net present value and rate of return methods. International Journal of Production Economics, 42(1), 79–96.

  • Remer, D. S., & Nieto, A. P. (1995b). A compendium and comparison of 25 project evaluation techniques. Part 2: Ratio, payback, and accounting methods. International Journal of Production Economics, 42(2), 101–129.

  • Weingartner, H. M. (1969). Some new views on the payback period and capital budgeting. Management Science, 15(2), 594–607.

Rights and permissions

Reprints and permissions

Copyright information

© 2015 Springer-Verlag Berlin Heidelberg

About this chapter

Cite this chapter

Götze, U., Northcott, D., Schuster, P. (2015). Discounted Cash Flow Methods. In: Investment Appraisal. Springer Texts in Business and Economics. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-662-45851-8_3

Download citation

Publish with us

Policies and ethics

Search

Navigation