Investment Analysis Methodologies - Discounted Cash Flow
Venture Capitalists, in absence of a solid predictable path, rely on these popular methodologies to arrive at crucial decisions about investments. Discounted cash flow and compound interest are two sides of a coin.
As we know, a dollar you have today is worth more than a dollar you'll have at some point in future, because you can invest today's dollar and earn interest on it starting today. Inflation hasn't eroded today's dollar yet.
Conversely it is true that a future dollar is worth less in today's terms so it has to be discounted to get it's present value. "Discounting" is a way of expressing the loss of interest income and/or erosion by inflation that you suffer by not getting that dollar until some point in the future.
There are ready tables available that shows how much $100, to be paid at the end of various periods in the future, is currently worth, with interest at different rates, compounded annually.
To use the table, find the vertical column under your interest rate (your cost of capital). Then find the horizontal row corresponding to the number of years it will take to receive the payment. The point at which the column and the row intersect is your present value of $100. You can multiply this value by the number of dollars you expect to receive, in order to find the present value of the amount you expect.
So for example if a Venture Capitalist has to wait for 6 years before he can expect any profits from the venture. Next he assumes 10% interest (cost of capital). After 6 years, his capital of $1,000,000 will be worth $564,400 in today's dollars! That is the time value of the money.
As we know, a dollar you have today is worth more than a dollar you'll have at some point in future, because you can invest today's dollar and earn interest on it starting today. Inflation hasn't eroded today's dollar yet.
Conversely it is true that a future dollar is worth less in today's terms so it has to be discounted to get it's present value. "Discounting" is a way of expressing the loss of interest income and/or erosion by inflation that you suffer by not getting that dollar until some point in the future.
There are ready tables available that shows how much $100, to be paid at the end of various periods in the future, is currently worth, with interest at different rates, compounded annually.
To use the table, find the vertical column under your interest rate (your cost of capital). Then find the horizontal row corresponding to the number of years it will take to receive the payment. The point at which the column and the row intersect is your present value of $100. You can multiply this value by the number of dollars you expect to receive, in order to find the present value of the amount you expect.
| years | 9.0% | 9.5% | 10.0% | 10.5% |
| 1 | $91.74 | $91.32 | $90.90 | $90.49 |
| 2 | $84.16 | $83.40 | $82.64 | $81.89 |
| 3 | $77.21 | $76.16 | $75.13 | $74.11 |
| 4 | $70.84 | $69.55 | $68.30 | $67.07 |
| 5 | $64.99 | $63.52 | $62.09 | $60.70 |
| 6 | $59.62 | $58.01 | $56.44 | $54.93 |
| 7 | $54.70 | $52.97 | $51.31 | $49.71 |
| 8 | $50.18 | $48.38 | $46.65 | $44.98 |
| 9 | $46.04 | $44.18 | $42.40 | $40.71 |
| 10 | $42.24 | $40.35 | $38.55 | $36.84 |
So for example if a Venture Capitalist has to wait for 6 years before he can expect any profits from the venture. Next he assumes 10% interest (cost of capital). After 6 years, his capital of $1,000,000 will be worth $564,400 in today's dollars! That is the time value of the money.