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How can you discount cash flows in a cost-benefit analysis?

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As a program manager, you may need to conduct a cost-benefit analysis (CBA) to compare the costs and benefits of different alternatives for your program. One of the key steps in a CBA is to discount the future cash flows to their present value, so that you can account for the time value of money and inflation. But how can you discount cash flows in a CBA, and what factors should you consider? In this article, we will explain the concept and formula of discounting, and provide some tips and examples on how to apply it in your program CBA.

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Shalini Selvaraj M.Tech,PMP?

Program Manager at Texas Instruments | Architect of Possibilities | Maestro of Impact
Angela Johnson

Expert in Developing Products, Businesses, and People in Life Sciences | Biotech, Medtech, & Health Tech | Women in…
Y Suresh Kumar

2 x LinkedIn Top Voice | Strategic Leadership | Program & Project | Operations & Supply Chain | Business Continuity &…

1 What is discounting?

Discounting is the process of converting future cash flows to their present value by applying a discount rate. A discount rate is the interest rate that reflects the opportunity cost of investing in a program, or the rate of return that could be earned elsewhere. The higher the discount rate, the lower the present value of future cash flows, and vice versa. Discounting helps you to compare the value of money at different points in time, and to evaluate the net benefits of a program over its life cycle.

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2 How to calculate the present value of a single cash flow?

To calculate the present value of a single cash flow, you need to use the following formula: Present value = Future value / (1 + Discount rate) ^ Number of periods For example, suppose you expect to receive $10,000 in five years from a program, and the discount rate is 8%. The present value of this cash flow is: Present value = $10,000 / (1 + 0.08) ^ 5 Present value = $6,805.28 This means that $10,000 in five years is equivalent to $6,805.28 today, given the discount rate of 8%.

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3 How to calculate the present value of multiple cash flows?

To calculate the present value of multiple cash flows, you need to add up the present values of each cash flow, using the same formula as above. For example, suppose you expect to receive $5,000 in three years, $7,000 in four years, and $10,000 in five years from a program, and the discount rate is 8%. The present value of these cash flows is: Present value = $5,000 / (1 + 0.08) ^ 3 + $7,000 / (1 + 0.08) ^ 4 + $10,000 / (1 + 0.08) ^ 5 Present value = $3,992.71 + $4,971.32 + $6,805.28 Present value = $15,769.31 This means that the total value of these cash flows is equivalent to $15,769.31 today, given the discount rate of 8%.

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4 How to choose a discount rate?

Choosing a discount rate for a Cost-Benefit Analysis (CBA) is a difficult decision, as it can significantly affect the present value of cash flows and the net benefits of a program. There is no definitive answer to what discount rate to use, as it depends on various factors such as the risk, uncertainty, and opportunity cost of the program, the social and environmental impacts, and the preferences and perspectives of the stakeholders. However, some common methods for estimating a discount rate include using the market interest rate or yield on government bonds as a proxy for the opportunity cost of investing in a program; using the social discount rate which reflects social welfare and intergenerational equity implications; utilizing the weighted average cost of capital (WACC), which combines the cost of equity and debt weighted by their proportions; and calculating the internal rate of return (IRR), which is the discount rate that makes the present value of cash flows equal to zero.

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Angela Johnson

Expert in Developing Products, Businesses, and People in Life Sciences | Biotech, Medtech, & Health Tech | Women in STEM and Inclusive Leadership Champion
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Money today isn’t worth the same as money tomorrow, a dollar’s “time value” is generally more today than in the future. When evaluate program investments, we use the “discount rate” to capture this change in the dollar’s value over time. ?? Low discount rate implies that the dollar of the future is similar or relatively higher than its value now (or “present value”) = risk of investing is low. ?? High discount rate indicates that future dollar will be worth less = higher risk investment. Mathematically, Discount Rate = (1 + r)^n, where: r = interest rate or cost of capital n = # periods In practice, most corporate investments use a cost of capital discount rate about 10%. High risk startups ~12-20%, & low risk bonds ~2-5%.

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5 How to deal with uncertainty and risk?

Uncertainty and risk are unavoidable in any program, and can significantly impact the accuracy and reliability of cash flow estimates and the discount rate. It is therefore essential to consider uncertainty and risk in your CBA, as well as assess the sensitivity of results to varied scenarios and assumptions. Probability distributions, such as normal, uniform, or triangular distributions, can be employed to represent the range and likelihood of possible cash flows and discount rates, while Monte Carlo simulation is a computer-based method that generates random samples from these distributions. Additionally, scenario analysis is a qualitative technique that creates alternative scenarios based on different assumptions and factors, such as optimistic, pessimistic, or most likely scenarios. Finally, real options analysis is a sophisticated method that values the option to modify, delay, or abandon a program in response to changing conditions.

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6 How to use discounting in a CBA?

In order to use discounting in a CBA, you must identify and estimate the cash flows of the program and its alternatives, including the costs and benefits, over the relevant time horizon. Subsequently, you must choose an appropriate discount rate based on the methods and factors discussed, and calculate the present value of the cash flows of each alternative. To compare the present value of costs and benefits for each alternative, you can calculate the net present value (NPV) or benefit-cost ratio (BCR). Ultimately, select the alternative with the highest NPV or BCR. Nonetheless, it is important to be aware of challenges and limitations associated with discounting, such as choosing a discount rate, dealing with uncertainty and risk, and incorporating non-monetary and intangible impacts. Therefore, it is wise to use caution and transparency when utilizing discounting, while also supplementing it with other methods and criteria for your program CBA.

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Shalini Selvaraj M.Tech,PMP?

Program Manager at Texas Instruments | Architect of Possibilities | Maestro of Impact
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??Discounting reflects that people prefer consumption today to future consumption, and that invested capital is productive and provides greater consumption in the future. ??Properly applied, discounting can tell us how much future and costs are worth today. Present value = Future value / (1 + Discount rate) ^ Number of periods.

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7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Y Suresh Kumar

2 x LinkedIn Top Voice | Strategic Leadership | Program & Project | Operations & Supply Chain | Business Continuity & Crisis Management | IIM Indore | ISB |IIM Bangalore | PMI-PgMP?,PMP?,ACP?,RMP?,LSSBB?
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Discounting involves adjusting future cash flows to their present value using a discount rate. This adjustment is applied in calculations of Net Present Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI). It accounts for the time value of money, reflecting that a dollar today is worth more than a dollar in the future due to factors like inflation and opportunity cost. However, the Payback Period doesn't involve discounting. It simply measures the time required for an investment to recover its initial cost through the generated cash flows. It focuses solely on the time taken to recoup the initial investment without considering the time value of money or discounting future cash flows.

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Kemal Atik
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I would propose considering Sensitivity Analysis and evaluating other metrics. Assessing the sensitivity of the NPV to changes against some of key variables such as discount rates or cash flow estimates can help to understand the impact of uncertainties on financial viability. Alongside NPV, other financial metrics such as the internal rate of return (IRR) and the benefit-cost ratio (BCR) could be evaluated to have comprehensive view of financial performance.

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How can you discount cash flows in a cost-benefit analysis?

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3

4

5

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7

1 What is discounting?

2 How to calculate the present value of a single cash flow?

3 How to calculate the present value of multiple cash flows?

4 How to choose a discount rate?

5 How to deal with uncertainty and risk?

6 How to use discounting in a CBA?

7 Here’s what else to consider

Program Management

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How can you discount cash flows in a cost-benefit analysis?

1

2

3

4

5

6

7

1 What is discounting?

2 How to calculate the present value of a single cash flow?

3 How to calculate the present value of multiple cash flows?

4 How to choose a discount rate?

5 How to deal with uncertainty and risk?

6 How to use discounting in a CBA?

7 Here’s what else to consider

Program Management

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