Finance Essay Example | Topics and Well Written Essays - 3000 words - 2

Finance - Essay Example Here the opportunity cost of capital is assumed to be 12%. Thus by adopting it as the discount rate for all future cash flows one can effectively obtain the NPV for them. This gives a few advantages. In the first place proper financial management requires a realistic opportunity cost to be set against capital. Though over a period of 5 years there can be considerable pressure on interest rates, a steady return of earnings would be ensured through proper cash flow management. After all the above cash flow forecasts are assumed to be constant though, in reality they might vary. The decision to make the investment is based on the apparent returns by way of future cash flows and it does not take into account the risk factor involved. For instance the investor has totally disregarded DCF method because he probably considers those future returns to be final and conclusive with respect to their values. The DCF calculations and the NPV figure of the total investment show that the decision is fairly justifiable because the NPV is equal to  £ 123,928.60 which is a considerable value against probable future inflationary pressure, i.e. the opportunity cost of capital. The importance of discounting future cash flows by using these formulas also depends on other factors as well. Discounted cash flows give a real picture of the future possibilities. Since DCF is what an individual is willing to pay at present in order to have what he expects to have in the future, it’s a process of expressing future revenue flows in terms of today’s value. Probably the most important reason behind DCF is the fact that inflation erodes the value of money in times to come, i.e. future. Therefore it’s essential to make up for the loss. That is why in each subsequent DCF multiplied by the number of years, a lower value comes up. The Internal Rate of Return (IRR) sets the present value of all future cash flows of an investment equal to zero.