Introduction
The Discounted Cash Flow (DCF) model is a method that investors use to estimate the value of an investment based on future cash flows. The DCF model uses the forecasted cash flows of investment to determine its value today. However, this tool isn't only for investors. Business owners and company shareholders can also use the DCF model to make decisions related to their existing companies in businesses.
The DCF model depends on a concept known as the time value of money. That's what the 'discounted' part of its name means. According to the time value of money concept, cash flows generated today are worth more than those generated in the future. Therefore, it requires users to discount cash flows using a rate of return, or cost of capital, for better decision-making.
Uses of Discounted Cash Flow Model
As mentioned above, there are many uses of the discounted cash flow model. Firstly, investors can use it to estimate the present value of an investment, which allows them to make better decisions. Companies may also use it to evaluate different projects and compare them with each other. The DCF model helps companies estimate the actual value of an investment, taking into consideration the time value of value, rather than its perceived value.
Some examples of how different entities can use the DCF model include determining the value of a company or a project. It may also include determining the value of the shares, bonds, and other instruments of a company. In short, the DCF model can be used to estimate the intrinsic value of any project or investment that generates cash flows.
Disadvantages of Discounted Cash Flow Model
The DCF model can also have some disadvantages. The model requires users to make different estimates. These estimates include forecasting cash flows of an investment or project, or the rate of return to use. Estimating these amounts is not as straightforward as they depend on certain internal and external factors. Therefore, a misestimation in these values can change the outcome of the decisions made by an entity.
Discount Cash Flow Model formula
The formula to calculate the cash flows of a particular instrument, investment, or project using the DCF model is straightforward. It involves discounting all the cash flows using an appropriate rate of return or cost of capital. Usually, calculating the present value of cash flows using the DCF model requires a proper structure, using a spreadsheet program. However, the formula can be presented as below.
DCF = [CF_{1} x (1+r)^{-1}] + [CF_{2} x (1+r)^{-2}] + … + [CF_{n} x (1+r)^{-n}]
In the above formula ‘CF’ represents the cash flow for each year. ‘r’ represents the required rate of return or cost of capital of a particular project or investment. Lastly, ‘n’ represents the total number of years of the project.
Example
A company wants to assess a 5-year particular project. The cost of capital of the company is 10%. The estimated cash flows from the project are as below.
Year |
Cash flow |
1 |
150,000 |
2 |
120,000 |
3 |
100,000 |
4 |
60,000 |
5 |
50,000 |
480,000 |
Using the DCF model, the company can calculate the present value of all cash flows using the 10% cost of capital. The calculation is as below.
Year | Cash flow | Discount factor (10%) | Present value |
1 | 150,000 | 0.909 | 136,350 |
2 | 120,000 | 0.826 | 99,120 |
3 | 100,000 | 0.751 | 75,100 |
4 | 60,000 | 0.683 | 40,980 |
5 | 50,000 | 0.621 | 31,050 |
480,000 | 382,600 |
Conclusion
The Discounted Cash Flow (DCF) model is a tool used to calculate the present values of the cash flows from a particular project or investment. Investors, shareholders, and companies use the model to determine the value of a particular investment or project. However, the model works with assumptions, which may affect the calculations.
Originally Published Here: Discounted Cash Flow Model
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