Discounted Cash Flow

The primary objective of a Discounted Cash Flow (DCF) analysis is to gauge the financial returns an investor can expect from an investment while accounting for the time value of money.
The time value of money theory posits that a dollar received today holds greater worth than a dollar received in the future because the former can be invested and yield returns. Therefore, DCF analysis proves beneficial in scenarios where someone is disbursing money in the present with the anticipation of receiving more funds in the future.
To illustrate, given an annual interest rate of 5%, $1 deposited in a savings account will appreciate to $1.05 in a year. Conversely, if a $1 payment is deferred for a year, its present value diminishes to 95 cents since it cannot be placed in a savings account to generate interest.
Discounted cash flow analysis calculates the current value of anticipated future cash flows by applying a discount rate. This approach assists investors in determining whether the forthcoming cash flows from an investment or project exceed the initial investment's value.
If the computed DCF value surpasses the current investment cost, the opportunity merits consideration. Conversely, if the calculated value falls short of the cost, further scrutiny and analysis may be necessary before proceeding.
To carry out a DCF analysis, an investor must make projections concerning future cash flows and the ultimate value of the investment, equipment, or other assets.
Selecting an appropriate discount rate for the DCF model is also crucial, and this rate can fluctuate depending on the specific project or investment in question. Variables such as the company's risk profile and prevailing capital market conditions can influence the choice of the discount rate.
In cases where forecasting future cash flows proves challenging or the project is exceptionally intricate, the utility of DCF may diminish, and alternative models should be explored.

The formula for DCF is:
DCF = CF1/(1+r)^1 +CF2/(1+r)^2 +CFn/(1+r)^n ​ ​
where:
CF 1 ​ =The cash flow for year one
CF 2 ​ =The cash flow for year two
CF n ​ =The cash flow for additional years
r=The discount rate ​

When a company analyzes whether it should invest in a certain project or purchase new equipment, it usually uses its weighted average cost of capital (WACC) as the discount rate to evaluate the DCF.

Cash Flow

Discounted Cash Flow