Question

Walk me through DCF (Discounted Cash Flows)

Please respond very accurately and in detail I need this for an interview.

Thanks! :)

Answer 1

Discounted cash flow method uses the present value of cash flows discounted at cost of capital or WACC. SInce cash flow is more accurate and realized as compared to net income.
It takes into consideration the expected free cash flows over the life of the project. These free cash flows are forecasted based on assumptions. The WACC is calculated by the average weighted cost of debt, equity and preferred stock. This method is used to value bonds, firms, projects etc.

WACC = Weight of Equity* Cost of Retained Earnings + Weight of Debt *Cost of Debt*(1-Tax Rate)
Discounted Cash flow = FCF in year 1/(1+WACC) +FCF in year 2/(1+WACC) ^2+FCF in year 3/(1+WACC)^3 ......FCF in year n/(1+WACC)^n

Assumptions in Discounted cash Flow
1.Risk free rate is assumed to remain constant over the life of the project.
2. The capital structure or debt equity ratio is considered to remain same over the life of the period.