Discounted Cash Flow (DCF)
Discounted cash flow analysis is a mechanism of evaluating a company, project or asset using the concepts of the time value of money. All future cash flows are assumed and discounted to provide their present values also known as PVs, which is the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is considered as the value or price of the cash flows in question.
Using Discounted cash flow analysis to compute the net present value accepts as input cash flows and a discount rate and renders as output a price. The inverse process is accepting cash flows and a price and deriving a discount rate is known as yield.
Discounted cash flow analysis is commonly used in real estate development, corporate financial management and investment finance.
The most popularly used mechanism of discounting is exponential discounting, which evaluates future cash flows as the amount of money would have to be invested at present, at a mentioned rate of return, to increase the cash flow in future. Other mechanism of discounting, such as hyperbolic discounting, are analyzed in academia and considered to reflect spontaneous decision making, but are not commonly used in the finance industry.
The discount rate used is in general, the appropriate weighted average cost of capital also known as WACC, that bring back the risk of the cash flows. The discount rate bring back two matters as mentioned below:
The time value of money as per the theory of investors, time preference would rather have cash with no time intervening than to wait and must therefore be counterbalanced by paying for the delay.
A risk premium shows the extra return investors demand because they want to be counterbalanced for the risk that the cash flow might not come into being after all.
An option to letting in the risk in the discount rate is to use the risk free rate, but multiply the future cash flows by the estimated probability that they will happen. This mechanism is commonly utilized in drug development. It is also known as risk-adjusted NPV. It is similar to the method used to integrate credit risk in the probability model of CDS valuation.
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