What is a Discounted Cash Flow ("DCF")?

What is a Discounted Cash Flow ("DCF")?

The discounted cash flow (or DCF) approach describes a method to value a project or an entire company using the concepts of the time value of money. The DCF methods determine the present value of future cash flows by discounting them using the appropriate cost of capital. This is necessary because cash flows in different time periods cannot be directly compared since most people prefer money sooner rather than later (put simply: a dollar in your hand today is worth more than a dollar you may receive at some point in the future). The same logic applies to the difference between certain cash flows and uncertain ones, or "a bird in the hand is worth two in the bush". This is due to opportunity cost and risk over time.

DCF procedure involves three problems

  • the forecast of future cash flows,
  • the incorporation of taxes (firm income taxes as well as personal income taxes),
  • the determination of the appropriate cost of capital (see WACC).

Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management.

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