What Is Discounted Cash-Flow Analysis?

Discounted cash-flow analysis compares the financial impact of buying a vehicle using cash today with paying for it over time through finance.

How Does Discounted Cash-Flow Analysis Work?

Paying out money today on a vehicle deprives you of cash which could be invested in assets to earn you money, such as a manufacturing machine (if you're a business) or a savings investment product (for a business or indivual).

The earnings generated by those assets can then be set off against the cost of financing a vehicle, reducing the real cost of vehicle finance.

Discounted cash-flow analysis compares the cost of buying the vehicle on finance (in other words, interest charges) with the investment return that could have been earned.

Example of Discounted Cash-Flow Analysis:

If you have £20,000 in the bank and want to buy a car today for £20,000, the car will cost you £20,000 today.

Let's say that instead you financed the car on a 0% finance deal for 1 year and you spent the £20,000 on a new widget making machine for your business which made profits of £1,000 for you over the next year.

The £1,000 is called the 'return on capital' or 'return on investment' and the amount of your return in this example means that the cost of the car would not be £20,000, it would be £20,000 minus the return made by your widget machine.

As a result, after 1 year the car costs you not £20,000, but £19,000 (£20,000 - £1,000 investment return).

Now, think of this £1,000 investment return as a discount on the price of the car.

Impact on finance repayments

The same principle can be applied to using ordinary monthly repayment finance or leasing to buy a vehicle.

Asuming your cash will earn you an investment return, after any initial deposit, each finance payment you make in the future costs you less than the face value of the payment.

This is because you will have earned an investment return on each finance payment until the date it is paid out.

Of course taxation might apply to the investment return, so when performing discounted cash-flow analysis you should always use a rate of return after tax when looking at cash-flows.

The principles of discounted cash-flow analysis apply equally to business and private buyers

VAT and tax relief

In a business, the same concept also applies to any VAT you can recover on the finance payments for a vehicle, or on tax relief for the vehicle against business profits, but here the principle is reversed.

A business will normally pay out the VAT on a finance repayment before it gets the VAT back (typically when the VAT return is submitted).

This means that the value of the VAT recovered in the future is less than the VAT paid out each month on the finance agreement.

This is because the business has lost the use of the VAT between the time it is paid out and the time it can be recovered and it could otherwise have used the VAT money to earn an investment return.

So, for the period that money is tied up in VAT paid to the leasing company, the lost investment return must be deducted from the value of the VAT refund obtained when the VAT return is submitted.

For example, let's assume a monthly lease payment is made at the beginning of a VAT quarter for £500 plus VAT (£100 at the current 20% VAT rate).

If the business recovers VAT at the end of the month after it submits quarterly VAT returns, the VAT on the lease payment will be recovered 4 months after it was paid.

On this basis, assuming a 5%pa investment return rate, by the time the business has recovered the £100 VAT on the lease payment it will be worth only £98.33.

This is because the business has lost the use of £100 for 4 months and could have gained an investment return at 4/12th of 5%pa on the £100 (£1.67).

The same principle applies to business tax relief on finance payments.

The tax relief on money paid to buy or lease company cars will be worth less when the tax relief is obtained because the business has lost the use of the money paid out until it files its tax returns and claims the tax relief.

Businesses such as limited companies typically pay tax 9 months after the end of an acounting period.

As a result, in discounted cash-flow calculations, the value of tax relief on money paid out, for example, at the beginning of a 12 month accounting period, would be reduced by the 12 months accounting year + 9 months wait for tax relief, a total of 21 months of lost investment return.

Simple vs compound return

To simplify the way investment interest is calculated on the monthly cash-flows in our analyses we use 1/12th of the annual rate of return and assume that each payment happens at the beginning of a month or period.

There are other methods of calculating investment return, such as compounding the interest rate monthly and/or assuming payments at the end of periods.

If you need discounted cash-flows calculated on a different basis then contact us.

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(+44 1792 224319 outside UK)