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The Little Book of Big Decision Models by Dr. Jim McGrath

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MODEL 59

DISCOUNTED CASHFLOW (DCF): CALCULATING TODAY’S VALUE OF TOMORROW’S RETURNS (THE FIRST 11)

Use this when comparing future cash flows as to which option provides the greatest return at today’s prices.

Inflation erodes the value of money over time. The value of £1,000 today is greater than in three years by which time inflation will have reduced its purchasing power. Which is why when calculating the return on an investment it’s necessary to take this reduction in value into account to arrive at the Net Present Value (NPV) of the cashflows.

The table below shows the NPV of cashflows derived from the purchase of a new machine costing £10,000 which will be replaced in five years. The discount rate is set at the predicted inflation rate ...

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