The discounted cash flow method overcomes the central weakness of the payback and ARR methods by focusing on cash flows and adjusting them to reflect the time value of money. To evaluate investment alternatives effectively, the cash outflows and inflows relevant to each proposal must be determined. As cash is used to pay bills and shareholder dividends, it is important to focus on cash flow and ensure that depreciation and other non-cash expenses associated with each proposal are added back to the accounting profit figures in order to arrive at the operating cash inflows.
The expected benefits from the project are measured using the incremental operating after-tax cash inflows. This method is concerned with how the firm’s total cash flows will change as a result of the investment decision. To do this, a comparison is made between: the firm’s current or existing total cash flows without the project; and the firm’s estimated future total cash flows, including the proposed project. The difference between (1) and (2) are the relevant incremental cash flows—the cash flows under (2) should be greater than (1). If they are not, then there is no point in proceeding. Changes in a company’s cash flows will alter a company’s tax liabilities.
For example, increased profits earned as a result of undertaking a capital project will increase the company’s liability to corporation tax. The tax on the profits is in itself a cash outflow as it must be paid to the Inland Revenue—it cannot be retained to add to the wealth of the shareholders. Therefore, it is only the incremental, after-tax cash flows associated with the decision at hand which should be considered.
Generally, there is a one-year time lag between earning the profits and payment of the tax, and any relevant tax losses in one year will normally be shown as a cash receipt in the next year. The information required to develop a discounted cash flow model are the estimated initial cash expenditure or outlay on the project; the estimated operating cash expenditure for each year of the project’s life; the estimated operating cash receipts each year; annual operating cash flow; the estimated termination cash flows if any, at the end of the project’s life; the estimated economic life of the project; and the rate of return required on the investment.