Discounted Cash Flow Analysis — A Critique

Discounted Cash Flow (DCF) is a tool to compare the financial returns from two or more ways of achieving the same objective. DCF assumes money has a value independent of the use of the money. It assumes money generates money because the financial system makes it possible. Unfortunately, unused money making more money leads to rentier behaviour and wrong choices between competing project options. In the abstract, the method looks sensible but it fails to account for human behaviour.

DCF reflects the risk of losing money, not the risk of project failure, as the underlying assumption is that the longer an investment lasts, the greater the risk. It assumes an uncertain future where money today is worth more than money tomorrow. DCF calculations show that the longer a project earns money, the greater the risk, whereas in practice, the longer a project can make money, the lower the risk. If the objective is to increase money, then DCF is sensible. If the aim is to increase goods and services from a given amount of money, DCF fails.

Discounted Cash Flows calculate Cost-Benefit Ratios. The approach is valid to choose between different implementations of the same project, but it does not hold when selecting various projects. Instead of selecting projects with the longest-lasting benefits, it chooses projects that give the highest monetary return. The early generation of money dominates the project selection.

The approach means that if there is a change in interest rate, then it is highly likely the project selection will appear incorrect. This conclusion is, of course, nonsense. The external change in the cost of money should not alter the calculation of the worth of a project.

Climate Change shows the absurdity of the approach. Here we have the actual risk of the destruction of the economy discounted to near zero to justify the continued burning of fossil fuels.

An alternative way to calculate Cost-Benefits

If we determine returns on investment by specifying the returns at the start of the project, we remove the need to use discounted cash flow analysis. The calculated returns depend on the projects, not a calculation dependent on factors outside the projects. Rather than choosing projects based on how much money they earn, we could select projects based on their savings.

Fixing the rate of return saves money because money no longer needs to earn money. By choosing the more reliable approach, we remove the unnecessary interest cost. Instead of giving returns on investment with interest, we provide returns on investment with goods and services resulting from the lower price of the goods. Instead of financing to get a return on the money, we invest to receive lower-cost goods and reduce the cost of finance.

Lower financial costs make many more projects economically viable and increase investment returns.

Calculations and estimates matter. Discounted Cash Flow Analysis is supposed to lead to better economic outcomes. Instead, it often leads to the perverse effect of increasing the cost of inferior projects.

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Kevin works on giving individuals control over their online information - particularly their financial information with local communities.

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Kevin Cox

Kevin works on giving individuals control over their online information - particularly their financial information with local communities.