Understanding Discounted Cash Flow (DCF) Rate of Return
The Discounted Cash Flow (DCF) Rate of Return, commonly known as the Internal Rate of Return (IRR) within the context of a DCF model, is a metric used to estimate the profitability of potential investments. Unlike simple return calculations, DCF analysis considers the time value of money—the concept that a dollar today is worth more than a dollar tomorrow.
How This Calculator Works
This calculator analyzes an investment based on an initial cash outflow (investment) and subsequent inflows (cash flows) over a 5-year period. It also accounts for a "Terminal Value," which represents the estimated sale price or remaining value of the asset at the end of the analysis period.
Initial Investment: The upfront cost required to acquire the asset or start the project.
Cash Flows (Years 1-5): The net income or free cash flow generated by the investment annually.
Terminal Value: The estimated value of the investment at the end of Year 5. This is added to the Year 5 cash flow for calculation purposes.
Discount Rate: Your required rate of return (often the Weighted Average Cost of Capital or WACC). This is used to calculate the Net Present Value (NPV).
Key Metrics Explained
Internal Rate of Return (IRR)
This is the true "DCF Rate of Return." It is the discount rate that makes the Net Present Value (NPV) of all cash flows equal to zero. If the IRR exceeds your required discount rate (or cost of capital), the project is generally considered financially viable.
Net Present Value (NPV)
NPV represents the difference between the present value of cash inflows and the present value of cash outflows over a period of time. A positive NPV indicates that the projected earnings (in today's dollars) exceed the anticipated costs.
Return Multiple (MOIC)
The Multiple on Invested Capital (MOIC) measures how many times you get your money back, ignoring the timing of the cash flows. A multiple of 2.0x means you doubled your initial investment in nominal terms.
Example Calculation
Imagine purchasing a small business for $100,000. You expect it to generate $15,000 in Year 1, growing slightly each year until Year 5. At the end of Year 5, you plan to sell the business for $80,000 (Terminal Value).
Even though the nominal cash received might be high, the DCF Rate of Return tells you the annualized percentage growth of that capital, factoring in that the money received in Year 5 is less valuable than money received in Year 1.
function calculateDCFReturn() {
// Clear errors
document.getElementById('errorMsg').style.display = 'none';
document.getElementById('results').style.display = 'none';
// 1. Get Input Values
var initialInv = parseFloat(document.getElementById('initialInvestment').value);
var discountRateInput = parseFloat(document.getElementById('discountRate').value);
var termVal = parseFloat(document.getElementById('terminalValue').value);
// Validation
if (isNaN(initialInv) || initialInv <= 0) {
showError("Please enter a valid Initial Investment amount.");
return;
}
// Get Cash Flows
var cfs = [];
for (var i = 1; i <= 5; i++) {
var val = parseFloat(document.getElementById('cf' + i).value);
cfs.push(isNaN(val) ? 0 : val);
}
// Validate Terminal Value
if (isNaN(termVal)) termVal = 0;
// 2. Prepare Cash Flow Array for Calculations
// Array structure: [Year 0 (negative), Year 1, Year 2, Year 3, Year 4, Year 5 + Terminal]
var flowArray = [];
flowArray.push(-Math.abs(initialInv)); // Year 0 is always outflow
for (var j = 0; j < 4; j++) {
flowArray.push(cfs[j]);
}
// Add Terminal Value to the last year's cash flow
flowArray.push(cfs[4] + termVal);
// 3. Calculate IRR (Newton-Raphson method)
var irr = calculateIRR(flowArray);
// 4. Calculate NPV
// Use user provided discount rate, or default to 0 if not provided just for display (though NPV at 0% is just sum)
var discountRateDecimal = (isNaN(discountRateInput) ? 0 : discountRateInput) / 100;
var npv = calculateNPV(discountRateDecimal, flowArray);
// 5. Calculate Metrics
var totalInflow = flowArray.slice(1).reduce(function(a, b) { return a + b; }, 0);
var totalReturn = totalInflow – initialInv;
var multiple = totalInflow / initialInv;
// 6. Display Results
var irrDisplay = (irr === null) ? "N/A (Non-convergence)" : (irr * 100).toFixed(2) + "%";
var npvDisplay = "$" + npv.toLocaleString(undefined, {minimumFractionDigits: 2, maximumFractionDigits: 2});
var totalReturnDisplay = "$" + totalReturn.toLocaleString(undefined, {minimumFractionDigits: 2, maximumFractionDigits: 2});
var multipleDisplay = multiple.toFixed(2) + "x";
document.getElementById('resIrr').innerHTML = irrDisplay;
document.getElementById('resNpv').innerHTML = npvDisplay;
document.getElementById('resTotalReturn').innerHTML = totalReturnDisplay;
document.getElementById('resMultiple').innerHTML = multipleDisplay;
document.getElementById('results').style.display = 'block';
}
function calculateNPV(rate, flows) {
var npv = 0;
for (var i = 0; i < flows.length; i++) {
npv += flows[i] / Math.pow(1 + rate, i);
}
return npv;
}
function calculateIRR(flows) {
// Newton-Raphson method
// Function to find root of: NPV(r) = 0
var maxIter = 1000;
var precision = 0.000001;
var guess = 0.1; // Start with 10% guess
for (var i = 0; i < maxIter; i++) {
var npv = 0;
var d_npv = 0; // Derivative of NPV with respect to r
for (var t = 0; t 0) {
d_npv -= (t * flows[t]) / Math.pow(1 + guess, t + 1);
}
}
if (Math.abs(npv) 1000) return null;
guess = newGuess;
}
return null; // No solution found within iterations
}
function showError(msg) {
var errDiv = document.getElementById('errorMsg');
errDiv.innerText = msg;
errDiv.style.display = 'block';
}