FIN4274

Disocunted Cash Flow

Week10
Chin Yen Zhan
Amanda
What is Dicounted Cash Flow (DCF)
• Discounted cash flow (DCF) is a valuation method used to estimate the value of
an investment based on its expected future cash flows. DCF analysis attempts to
figure out the value of an investment today, based on projections of how much
money it will generate in the future. This applies to both financial investments for
investors and for business owners looking to make changes to their businesses,
such as purchasing new equipment.
(Chen, 2020)
How DCF works?
• The purpose of DCF analysis is to estimate the money an investor
would receive from an investment, adjusted for the time value of
money. The time value of money assumes that a dollar today is worth
more than a dollar tomorrow because it can be invested. As such, a DCF
analysis is appropriate in any situation where a person is paying money
in the present with expectations of receiving more money in the future.
• For example, assuming a 5% annual interest rate, $1.00 in a savings
account will be worth $1.05 in a year. Similarly, if a $1 payment is
delayed for a year, its present value is $.95 because it cannot be put in
your savings account to earn interest.
• DCF analysis finds the present value of expected future cash flows
using a discount rate. Investors can use the concept of the present
value of money to determine whether future cash flows of an
investment or project are equal to or greater than the value of the
initial investment. If the value calculated through DCF is higher than
the current cost of the investment, the opportunity should be
considered.
DCF Formula
Example of DCF :
• When a company looks to analyze whether it should invest in a
certain project or purchase new equipment, it usually uses its
weighted average cost of capital (WACC) as the discount rate
when evaluating the DCF. The WACC incorporates the average
rate of return that shareholders in the firm are expecting for the
given year.
Example of DCF (cont) :
• You are looking to invest in a project and your company's WACC is 5%, so you will use 5% as your discount
rate. The initial investment is $11 million and the project will last for five years, with the following estimated
cash flows per year:

• If we sum up all of the discounted cash flows, we get a

value of $13,306,728.
• Subtracting the initial investment of $11 million, we get
a net present value (NPV) of $2,306,728.
• Because this is a positive number, the cost of the
investment today is worth it as the project will generate
positive discounted cash flows above the initial cost.
• If the project had cost $14 million, the NPV would have
been -$693,272, indicating that the cost of the
investment would not be worth it.
 Advantages of DCF
1) Accuracy and Reliability
Corporate finance textbook authors Jonathan Berk and Peter DeMarzo say that using
discounted cash flow to reduce investments to net present value is "the most accurate
and reliable" method there is for making investment decisions. Provided that the
estimates that go into the calculations are more or less correct, no other method does
as good a job at identifying which investments produce maximum value.

2) A Single Value
A big advantage of the discounted cash flow model is that it reduces an investment to
a single figure. If the net present value is positive, the investment is expected to be a
moneymaker; if it's negative, the investment is a loser. This allows for up-or-down
decisions on individual investments. Further, the method allows you to make choices
among significantly different investments. Project each investment's cash flows,
discount them to present value, add them up, and compare them. The one with the
highest net present value is the most profitable alternative.
 Advantages of DCF

3. They are more objective, for their conclusions are not directly influenced by
decisions regarding depreciation methods, capitalization versus expense decisions
and consideration.

4. The DCF method automatically gives more weight to units of money, which are
nearer than those, which are distant. But other methods treat distant units of money
unrealistically with the same weight as present units.

5. The DCF method allows a ready comparison to be made between projects having
different lives and different timings of each flow by facilitating comparison at the
same point of time.
 Disadvantages of DCF
1) Vulnerable to Estimation Errors
Discounted cash flow valuation is only as good as the estimates that go into it. If
those estimates are flawed, the net present value will be inaccurate, and you may
make bad investment decisions. The model offers multiple opportunities for error. All
projected cash flows are just that: projections. They're estimates -- educated
guesses. Plus, the discounting formula used to convert those cash flows to present
value includes another estimate -- the discount rate, which is the rate by which you
assume a certain sum of money will change in value over time.

2)DCF methods are considered difficult to understand and operate. However,

compared to the complexities associated with some modern statistical and
mathematical tools, which have gained acceptance in recent times, DCF techniques
are simple to understand.
 Disadvantages of DCF
3. The third assumption is against the assumption of a fixed investment rate
throughout the life of the project. This assumption arises mainly because of the use
of compound interest principle as the basis of these methods.

4. The forth criticism is that they fail to take account of risks and uncertainties.
However, recent developments in risk analysis, which could be incorporated into
DCF methods, have made this criticism somewhat irrelevant.

5. It is said that the IRR and NPV methods give rise to conflicting issues while
decisions are taken. Recent theoretical refinements have mitigated most of the
weaknesses of these methods.
References
• Chen, J., 2020. Discounted Cash Flow (DCF). [online] Investopedia.
Available at: <https://www.investopedia.com/terms/d/dcf.asp> [Accessed
27 October 2020].
• https://bizfluent.com/info-8292717-advantages-disadvantages-
discounted-cash-flow.html
• https://smallbusiness.chron.com/advantages-disadvantages-discounted-
cash-flow-40383.html