Discounted cash-flow method

Various other evaluation schemes based on the concept of time value of money are also sometimes used. These, together with the Net Present Value and Rate of Return methods, are all grouped together under the title of discounted cash flow methods. 

The key to the discounted cash flow methods is the determination of a proper interest rate. For this, two factors must be known. One is how much does it cost to obtain money The second is what is a reasonable amount of profit to expect from a plant The first depends on the source of money. This can be corporation earnings, the sale of stock, the issuance of bonds, the selling of assets, or borrowing from some outside source. The second depends on economic conditions. 

Finally, we are in the business to produce products and profits. Broadly, if a product is made in 3-4 reaction steps in the batch-manufacturing environment, the market value should be 10 times the materials. If market value is only twice the raw material cost, the project should be redefined or stopped. In a 10-step process, it is not uncommon that materials are 1/20 of the selling price. A comparison of a two reaction step product using discounted cash flow methods (11) showed that a process with a market value 4 times the materials was greatly preferred over one at 3 times materials. 

Discounted Cash Flow In the discounted cash flow method, all the yearly after-tax cash flows are discounted or compounded to time zero depending upon the choice of time zero. The following equation is used to solve for the interest rate i, which is the discounted cash flow rate of return (DCFROR). 

Inits economic model (3), NRELused the discounted cash flow method to calculate the yearly total equipment cost for different process sections. To simplify economic comparisons between the two pretreatment designs,... 

The same methods that were explained and applied earlier in this chapter are applicable for replacement analyses. Net-present-worth and discounted-cash-flow methods give the soundest results for maximizing the overall future worth of a concern. However, for the purpose of explaining the basic principles of replacement economic analyses, the simple rate-of-retum-on-investment method of analysis is just as effective as those methods involving the time value of money. Thus, to permit the use of direct illustrations which will not detract from... 

In the present worth (or discounted cash flow) method, each annual net cash flow for a project is discounted to the beginning of the project (year zero), in order to express all cash flows on the same basis. This discounting is done via the following equation ... 

Two small commercial incineration facility designs are under consideration. The first design involves a liquid injection incinerator and the second a rotary kiln incinerator. For the liquid injection system, the total capital cost (TCC) is 2.5 million, the annual operating costs (AOC) are 1.2 million, and the annual revenue generated from the facility R) is 3.6 million. For the rotary kiln system, TOC, AOC, and R are 3.5, 1.4, and 5.3 million, respectively. Using straight-line depreciation and the discounted cash flow method, which design is more attractive Assume a 10-yr facility lifetime and a 2-yr construction period. Note that the solution involves the calculation of the rate of return for each of the two proposals. 

Hence, by the discounted cash flow method, the rate of return on the initial capital investment is approximately 5% greater for the rotary kiln system than the liquid injection system. From a purely financial standpoint, the rotary kiln system is the more attractive. 

A more sophisticated approach is to use risk-adjusted discounted cash flow methods that properly account for the nondiversifiable risk associated with fossil fuel price volatility and the lower diversifiable risk associated with capital projects. Application of this more robust financial analysis leads to a significant change in the costs of technologies. Table 6 suggests that the renewable technologies become slightly less costly while nuclear and fossil fuels, particularly gas, become significantly more expensive (in some cases the cost more than doubles). Furthermore, the cost rank order alters such that, with the exception of solar thermal, renewables become cheaper than the fossil fueled and nuclear options. 

A widely used method of analysis Is that based upon the Internal rate of return. Also known as the Discounted Cash Flow method, this approach Is based on the criterion that the sum of the present value of all cash flow returns associated with a given project be equal to the Initial Investment outlay namely,... 

The principal value of spreadsheets, other than their universal acceptance and use over the past decade, is the ability to display efficiently and use individual estimates of costs and benefits for each period over the life of the project, reflecting anticipated variability rather than a uniform average value or an approximate mathematical series. This will be discussed as each discounted cash flow method is presented. The principal disadvantage of a spreadsheet is that computational errors are hidden, even though an audit tool exists. However, the problem of quality assurance is not a new one, and the engineer must always be alert to the prevention and elimination of errors. 

If the equity value is estimated by using the discounted cash flow method, the cost of capital assumes a particular relevance. Conventionally, the cost of capital is estimated through the capital asset pricing model (CAPM) that was introduced by Sharpe (1964) and subsequently improved by Lintner (1965). One of the most important variables is beta. Beta measures the sensitivity of the asset s or company returns to variation in the market or index returns. Therefore, according to CAPM theory, the risk assumed from an investor depends on the covariance (or correlation) between individual assets and market portfolio. Thus, if these singular assets do not have correlation, they will not add risk differently, if the correlation is positive they will add risk on market portfolio. 

Most R D projects involve expenditures and savings over a period of years. To connect the value of cash flows with different time periods, it is essential to employ a cash flow analysis method that takes into account the time value of money. In finance, such methods are called discounted cash flow methods. A particularly useful method is the net present value (NPV) analysis. The NPV measures the difference between the present value of cash inflows and the present value of cash outflows. It is defined as... 

Nonstrategic financial Optional projects that reduce cost or increase revenues Financial Discounted Cash Flow methods (ROI, NPV)... 

Selection criteria may be based on a required level of corrosion resistance to meet safety and reliability requirements. More likely, selection will be based on economic considerations. Least first-cost usually is not appropriate and some type of evaluation of life-cycle cost is preferred. There are many methods for making such life-cycle cost analyses. The discounted cash flow method is ideally suited to life-cycle cost analyses that consider both first costs and costs for maintenance and repair over the system lifetime [3]. 

Over the projected life of the structure, the total cost of maintaining the structure, including the costs of inspection, maintenance, and repair, easily can exceed the initial cost. Economic analyses such as the discounted cash flow method allow the designer to minimize the annual cost of ownership of a system by balancing the various costs involved. In many cases, reduction in maintenance through... 

The discounted-cash-flow method of determining ROI indicates in a more realistic manner the equipment cost and return on investment by considering ... 

Supports "driving force" Responds to a dMiciency, or Incorporates common new technology expected of industry participants Financial discounted cash flow methods (ROl, NPV)... 

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