Question

2. Describe the basic principle of DCFs and how they can be used to compare different streams of cash flows.

Answer 1

Discount Cash Flow provides the details about the prospects of investment. It is mainly based on time value of money. Time value of money says that money at present worth more than money after sometime. For example, a certain amount invested might increase in value after one year because of interest added to it.

Discount cash flow considers various cash flows in future. With appropriate discount rate, present values will be obtained from these predicted cash flows. If the value obtained from this procedure is more than the present value, then positive returns might be expected if this cash flow happens. The discount rate is obtained using the weighted average cost of capital. Average rate of return expected by the shareholders will be obtained through weighted average cost of capital.

This is highly useful in comparing various cash flows, and in most cases accurate as well. But the problem is with the prediction of cash flows. Any prediction is not certain, so some level of uncertainty creeps into this DCF analysis.