Discounted cash flow (DCF) is a valuation method used to assess the potential of capital or security investments. It can also be used to value a particular project or an entire company. The idea behind discounted cash flow is that the present value is based on the sum of all future cash flows, adjusted for the time value of money.
This adjustment is made to recognise that a cash flow that will be received in the future has a lower present value. Therefore future cash flows are discounted to their present value by applying a discount rate. The discount rate typically has two components: an adjustment for inflation and a risk-adjusted return for the use of the money.
When deciding whether to make a specific investment the discount rate can be considered as the minimum required rate of return. Companies would normally use their own average cost of capital (debt and equity) as the discount rate, as only an investment that exceeds the cost of capital would add value to the company.
In order to calculate the net present value of an investment or a project, the following steps need to be taken:
- Identify the size and timing of the expected future cash flows.
- Determine the discount rate or the required rate of return for the project.
- Calculate the present value of the cash flows using an equation such as this one:
\(DCF \: = \: \frac{Cash \: flow \: year \: 1}{1 \: + \:r^1} \: + \: \frac{Cash \: flow \: year \: n}{1 \: + \:r^n} \: \: or \: DCF \: = \sum_{t=0}^{N}\frac{CF_t}{1\:+\: r^t}\)
For example, a company has a required rate of return (r) of 8% and considers investing in a new business venture. The initial outlay for the project will be €140,000. Annual running costs are estimated at €60,000 and cash inflows are expected to be €100,000, resulting in a net annual cash flow of €40,000 (after taxes). No further cash flows are expected after five years, when the project will be phased out. Using the DCF formula, the net present value (NPV) of the project can be calculated as the sum of all cash flows discounted to their present value less the initial outlay.
\(NPV = \frac{40000}{1 \: + \:{\frac{8}{100}}1} \: + \frac{40000}{1 \: + \:{\frac{8}{100}}2} \: + \: \frac{40000}{1 \: + \:{\frac{8}{100}}3} \: + \: \frac{40000}{1 \: + \:{\frac{8}{100}}4} \: + \: \frac{40000}{1 \: + \:{\frac{8}{100}}5} \: – \: 140,000 \: = \: 19708.4 \)
As the NPV is positive the company should consider the investment. In theory, any investment with a positive NPV should be made. However, as funds are limited, companies would choose the investments or projects they want to pursue by employing an NPV index. This index is calculated by dividing the NPV of each investment or project by the initial cash outlay. A higher index will then indicate a more advantageous investment opportunity.
There are many variations used in DCF calculations, which all serve the purpose of estimating the cash flows that will be received from an investment adjusted for the time value of money. The main difficulties in using DCF are estimating the size and timing of future cash flows, determining the most appropriate discount rate and projecting how the discount rate is going to change over time. The calculation also takes no account of the certainty of the anticipated cash flows.
