Overview of Discounted Cash Flow
The Discounted Cash Flow is a way of determining the value of a business venture, a financial property or a business entity. The Discounted Cash Flow method uses the notion of time value of money. The method is one of the most often used financial concepts in the modern business sector.
Domain of Discounted Cash Flow
The Discounted Cash Flow method is applied to a great extent in the following business sectors:
- Investment Finance
- Corporate Financial Management
- Real Estate Development
Description of Discounted Cash Flow Method
The Discounted Cash Flow functions in a particular way. In this method the expected cash flows are calculated. The present value of the cash flows in future is obtained by discounting the estimated future cash flows.
The rate of discount used in this case is normally the suitable cost of capital. The rate of discount also includes the risk factors that may be involved in the future cash flows.
Equational Representation of Discounted Cash Flow
The Discounted Cash Flow could be represented through the following equation:
DCF = CF1 / (1+ r)1 + CF2 / (1+ r)2 + … + CFn / (1 + r)n
In this formula CF stands for cash flow and r represents the rate of discount.
Discounted Cash Flow in Mathematics
The method of Discounted Cash Flow is used in Mathematics as well. The formula for Discounted Cash Flow has been deduced from the future value formula. The future value formula is used to calculate the following:
- Compounding Returns
- Time Value of Money
The following equation represents the Discounted Cash Flow formula:
FV = PV. (1 + i)n
Following is the simpler version of the Discounted Cash Flow formula:
DPV = FV / (1 + d)n
The details of this formula can be provided in this table:
|Symbol||Representation or Meaning|
|n||The number of discounting periods that have been used|
|DPV||The discounted present value of the cash flow in future|
|d||The rate of discount. It is a combination of opportunity and risk factor|
|FV||The basic worth of amount of cash flow in the future|
When discounted cash flows are available for a number of time periods the Discounted Present Value is obtained by summing all of those previously calculated values. The following equation could be provided in this instance:
DPV = S t FVt / (1 + d)t , where t varies from 0 to N.
Here, FV stands for future cash flow and t stands for any time period. This sum could be used in the following ways:
- To further determine the internal rate of return of a trend of cash flow for a certain period of time
- As a figure of net present value
Last Updated on : 1st July 2013