Discounted
cash flow is the financial equivalent of a bird in the hand being
worth two in the bush.
"Somebody can give you $100 today, or they can give you $100 over
four years in $25 payments. But the latter arrangement isn't worth
as much as all the money up front. It's that simple," says Susan
Koski-Grafer, a vice president at the Financial Executives Institute
in Morristown, N.J.
To calculate discounted cash flow, you need to look at three
things: the initial cash down, the monthly payments and residual
asset value. These elements apply whether you're calculating the
value of cash paid out over the term of a 30-year home mortgage or a
three-year PC hardware lease. That's because all that money has a
time value associated with it.
For example, a user company can save money in an information
technology leasing deal by not paying for hardware in full. Instead,
its cash flow is discounted because it pays over several years,
which makes sense because the value of a PC or other hardware
depreciates over time. So renegotiating a lease on the same
equipment requires IT managers to calculate what they have paid --
the down payment and monthly fees -- and subtract that from the
amount it would have cost to purchase the PCs up front. What's left
is the residual value of the asset (see chart).
By doing the discounted cash flow calculation, you come up with a
figure you can use when negotiating to buy the hardware you had been
leasing.
"It's the same with leasing a car. You pay a lot of money in lieu
of interest, plus you pay for the actual rental of the car and the
depreciation on it," says Donald Orr, professor of management at
LaRoche College in Pittsburgh.
What some users don't understand is that vendors frequently try
to renew a lease based on the price they could get for the equipment
on the secondary market -- the market value. That's usually higher
than the residual value. It's the equivalent of the Blue Book value
in the automobile world.
IT managers who know discounted cash flow calculation have a
negotiation advantage because they can predict a vendor's behavior,
Koski-Grafer notes.
A savvy IT manager can point out how much more convenient it is
for the vendor to re-lease the equipment, even at the residual
value. "The manager can say, 'Here's a deal on the table. We do this
and it's done,' " Koski-Grafer says.
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