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What is Discounted Cash Flow (DCF)?

Definition: Discounted cash flow (DCF) is a model or method of valuation in which future cash flows are discounted back to a present value using the time-value of money. An investmentís worth is equal to the present value of all projected future cash flows.

What Does Discounted Cash Flow Mean?

What is the definition of discounted cash flow? Itís a way of evaluating a potential investment by estimating future income streams and determining the present worth of all of those cash flows in order to compare the cost of the investment to its return.

When a business is trying to determine how to spend capital, it is important to determine whether or not investments will result in a positive return. The DCF method allows management to determine the value of the future projected revenues in todayís dollars. Management can subtract the amount spent on the investment from the present value of future cash flows to calculate the net present value of the investment.

In other words, they can calculate how much money the investment will make in todayís dollars and compare it with the cost of the investment.

Letís look at an example.

Example

Tom is the CFO of a mid-sized company in Atlanta. Company leadership is trying to determine whether or not to invest in a new piece of machinery to make their manufacturing process more efficient. This machine would cost the organization $1,000,000 and its life is 5 years. What is the net present value of this investment using the discounted cash flows method?

The CFO determined the discount rate to be 10%. With this information, he calculated the following future cash flows:

  • Year 1 = $130,000
  • Year 2 = $150,000
  • Year 3 = $200,000
  • Year 4 = $210,000
  • Year 5 = $200,000

The total of these cash flows is $890,000. The net present value of this investment is $890,000-$1,000,000 which is equal to -$110,000. The company should not make this investment because the cost is greater than the value of the future income creating a negative return over the time period.

Using this calculation, investors should only make an investment if the NPV is greater than 1.

Summary Definition

Define Discounted Cash Flow: DCF means an investment analysis model that calculates the value of an investment based on the present value of its future income.

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