Sorry Sylvia, I should have included in my previous post; Please explain how DCF is related to the examples you gave.

OK, I'll have a go at explaining this. I'm going to make some assumptions here. Anyone who quibbles about them will be ignored, because they're only to illustrate the point.

Let's suppose I'm using 100 kilolitre of water per year, and it's costing me $1 per kilolitre. Now suppose that I can buy a water tank for $1800 that will give me 100 kilolitres per year, and that the tank will last 20 years.

So I pay $1800 for the water tank, and save $2000 on water charges. So I'm $200 ahead, right?

Wrong!

The reason it's wrong relates to what I can do with the $1800 if I do not spend it on a water tank. Indeed, if what I do is put it under the mattress, and pull out $100 every year to pay my water bill, then I would be better off with the tank, but a rational person wouldn't do that. The most obvious thing to do with it is put it on deposit at the bank.

Suppose I can get 4% interest on my deposit. Then at the end of the first year, I'll earn 72 dollar in interest, but I'll need to withdraw $100 to pay the water bill, leaving $1772.

Since the deposit has reduced a bit, at the end of the second year, I'll earn $70.88 in interest, and withdraw $100 to pay the water bill, leaving $1742.88 in the account.

And so on, for 20 years, at the end of which the account will contain $966.21.

Now, if I buy the tank, then after 20 years is up, the tank is worn out, and has to go to the tip, so I have no tank, and no cash. On the other hand, if I put the money in the bank, then after twenty years I still have no tank, since I didn't buy one, but I have $966.21 in cash.

Clearly, I'm better off if I don't buy the tank. In fact, to break even on the deal, I'd have to be able to buy the tank for less than $1360

What Tha ??

Thanks for that, now I understand.I think? That is a little understating DCF. Just for kicks try Googling "Discounting Cash Flow".

This is good Sylvia. Now I understand your perspective.

I did google Discounted Cash Flow straight after I read your initial post. But I must say it didn’t help much.

OK, so what you are really saying is that we need to consider the true economics, or financial comparisons, including interest rates and things that we might be able to do with that money if we don’t spend it on a water tank for example.

Fair enough. But we also need to think about a few other things. For example, with water tanks, we should consider the principle of supplying one’s own water in a water-stressed public-supply regime and how that adds to one’s feeling of secure supply and not having to worry about restrictions, one's sense of wellbeing, one’s impression on neighbours and friends and one’s sense of positive contribution in the wider community.

Different people place very different values on this sort of thing. For many people, this would completely override hard financial considerations.

So, could you now please explain why “Discounted cash flow is the reason our base load power stations run on coal, but peak load power stations run on other fuels. It’s the reason we do not have a high-speed railway running between Melbourne and Sydney. It’s also the reason no sane person puts photovoltaic panels on their roof, converts their low usage car to LPG, replaces a working hot-water system with solar…”

Thanks

ALAMO

Certainly my approach to presenting this is not classical DCF, and I reached the limit on words and posts.

I'm trying to explain it in a way that will be believed, rather than seen as an obscure, and therefore questionable, accounting technique The results are the same, though doing it the way I described has its limitations, the most obvious being that it's difficult to compare alternatives solutions that have different lifetimes.

What classical DCF says is that each item of income and expenditure should discounted by a rate that depends on the period between now and when the item occurs. In the rainwater example, the discount rate is 4%, or 1.04, so the first payment should be discounted by that factor, giving $96.15 cents, the second is discounted by 1.04 squared, giving $92.45, and so on until last payment is discounted by 1.04 to the power 20, giving $45.63. The point of these discounts is that they give what is called the present value of the future payments. They can then be added together, giving $1359. This is the "Net Present Value", or NPV, of the future payments, and is the amount I should be comparing with the NPV of the tank (which is just its price in this case) when making my investment decision. If you put that number into my bank deposit analysis, you’ll find that at the end of 20 years, the account balance is zero. That is, it’s the break even point.

The essential point in my original posting was not that people should rush out and start learning investment accounting techniques, though that wouldn’t hurt, but that they should be aware of their own limited understanding, and not assume that a simplistic approach gives the correct answer, nor that counter-intuitive answers are necessarily wrong.

I’d make an exception for some Greenies though – they should be forced to study this, and not be allowed out of the classroom until they’ve got it, because they spout a lot of total nonsense due to their (sometimes wilful, I think) ignorance of it.