Question

Give an example of a situation where a building contractor may want to use the discounted cash flow (DCF) analysis method.

Answer 1

DCF : Discounted cash flow is the method of valuation. It is the method to value the investment today based on it's future cash flow. The present value of investment is then helpful to consider the potential investment. If the present value calculated from DCF model is less then the future value the investment is worth considering.

For eg:

Suppose a building contractor will take 3 years to complete a building and the interest rate is 8%p.a. His estimation of revenue after completion of building is $10,000,000.

Now if the expenses to construct a building is less then $10,000,000 in period of 3 years with 8% cost of capital then the investment in constructing building is considered fruitful.

  

Present value = futures value/1+r ^t

PV = 10,000,000/1+0.08^3

= 10,000,000/1.260

= $7,936,507

Therefore if cost of constructing a building is $7,936,507 for 3 years and the opportunity cost of investing the same amount today for future is less then $10,000,000 then investing in building is good option.