The cash flow model to analyze investments is superior to the direct capitalization method (cap rates) because it reflects the time value of money, which is the idea that money that is available today is worth more than the same amount tomorrow. The core principle behind this is that money can earn interest and, therefore, the sooner it is received the longer time it has to grow.
One of the key features of the cash flow model is that it takes into account the time value of money. By quantifying not only the amount of cash flows, positive or negative, but also the timing of the cash flows the cash flow model addresses the following 4 basic questions:
- How many dollars go into the investment?
- When do the dollars go into the investment?
- How many dollars come out of the investment?
- When do the dollars come out of the investment?
The answers to these questions provide investors the information they need to choose between investment alternatives. In general, rational investment decisions are governed by 2 basic preferences:
- More is better than less
- Sooner is better than later
Therefore, with all else being equal, investors will prefer an investment with:
- Larger periodic cash flows
- Larger sale proceeds
- Lower initial investment
- Earlier periodic cash flows