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Discounted cash flow

Explanation of discounting cash flow (DCF) with formula and examples.

Discounted cash flow (DCF) is a method used to value an investment based on its expected future cash flows. DCF analysis aims to determine the investment's present value by projecting the amount of money it will generate in the future.

DCF analysis can be helpful for individuals and businesses considering acquisitions, investments in securities, or making decisions about capital budgeting or operating expenditures. It can assist in determining whether an investment will result in positive returns and is worth pursuing.

To calculate the present value of future cash flows, the DCF formula uses a projected discount rate. The weighted average cost of capital (WACC) is typically used by companies as the discount rate because it considers the shareholders' expected rate of return.

Key takeaways

  • The DCF formula is: DCF = CF1 / (1+r)^1 + CF2 / (1+r)^2 + CFn / (1+r)^n

  • The DCF formula is based on the principle of the time value of money, which recognizes that a pound today is worth more than a pound in the future because it can be invested to earn interest.

  • DCF analysis is commonly used in investment banking, private equity, and real estate. Business owners can also use it to make budget decisions and determine their company's value.

What is the formula for discounted cash flow?

The DCF formula is as follows:

DCF = CF1 / (1+r)^1 + CF2 / (1+r)^2 + CFn / (1+r)^n

Where:

CF1 = Cash flow for year one

CF2 = Cash flow for year two

CFn = Cash flow for additional years

r = Discount rate

Discounted cash flow example

For example, if a company's WACC is 5%, and the initial investment is £11 million with expected cash flows over five years as follows:

Year 1: £1 million

Year 2: £1 million

Year 3: £4 million

Year 4: £4 million

Year 5: £6 million

Using the DCF formula, the calculated discounted cash flows for the project are:

Year Cash Flow Discounted Cash Flow (nearest £)

1 £1 million £952,381

2 £1 million £907,029

3 £4 million £3,455,350

4 £4 million £3,290,810

5 £6 million £4,701,157

Adding up all the discounted cash flows results in a value of £13,306,727. Subtracting the initial investment of £11 million from that value yields a net present value (NPV) of £2,306,727. If the NPV is positive, the investment may be worth pursuing; if negative, more research may be needed before making a decision.

The DCF formula is based on the principle of the time value of money, which recognizes that a pound today is worth more than a pound in the future because it can be invested to earn interest. However, DCF analysis relies on estimates of future cash flows, which may not be accurate, and factors such as market demand, the economy, and technology may affect future cash flows.

DCF analysis is commonly used in investment banking, private equity, and real estate. Business owners can also use it to make budget decisions and determine their company's value.

To perform a DCF analysis, an investor must make estimates about future cash flows and determine an appropriate discount rate. Companies should also consider other factors, such as comparable company analysis and precedent transactions, when evaluating investment opportunities.

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