Question

Identify and elaborate Discounted Cash Flow (DCF) and provide one example.

Answer 1

Discounted Cash Flow (DCF) is a valuation method used to estimate the value of an investment based on its future cashflows. DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future. This applies to both financial investments for investors and for business owners looking to make changes to their businesses,, such as purchasing new equipment.

The Present value of expected future cashflows is arrived at by using a discount rate to calculate the Discounted Cash Flow (DCF). If the Discounted Cash Flow (DCF) is above the Current Cost of the invetment, the opportunity could result in positive returns. Companies typically use the weighted average cost of capital for the discount rate, as it takes into consideration the rate of return expected by shareholders. The DCF has limitations, primarily that it relies on estimations on future cahflows, which could prove to be inaccurate.

The purpose of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money. The time value of money assumes that a dollar today is worth more than a dollar tomorrow because it can be invested. As such, a DCF analysis is appropriate in any situation where a person is paying money in the present with expectations of receiving more money in the future.

Example: Assuming a 5% annual interest rate, $1 in a bank account will be Worth $1.05 in a year. Similarly, if a $1 payment is delayed for a year, its present value will be $0.95 because it can not be put in your bank account to earn interest.