Discounted cash flow

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Discounted cash flow calculations have been used in some form since money was first lent at interest in ancient times. As a method of asset valuation it has often been opposed to accounting book value, which is based on the amount paid for the asset. Following the stock market crash of 1929, discounted cash flow analysis gained popularity as a valuation method for stocks. Irving Fisher in his 1930 book "The Theory of Interest" and John Burr Williams's 1938 text 'The Theory of Investment Value' first formally expressed the DCF method in modern economic terms.

In finance, the discounted cash flow (or DCF) approach describes a method to value a project or an entire company using the concepts of the time value of money. The DCF methods determine the present value of future cash flows by discounting them using the appropriate cost of capital. This is necessary because cash flows in different time periods cannot be directly compared since most people prefer money sooner rather than later (put simply: a dollar in your hand today is worth more than a dollar you may receive at some point in the future). The same logic applies to the difference between certain cash flows and uncertain ones, or "a bird in the hand is worth two in the bush". This is due to opportunity cost and risk over time.

DCF procedure involves three problems

• the forecast of future cash flows,
• the incorporation of taxes (firm income taxes as well as personal income taxes),
• the determination of the appropriate cost of capital.

Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management.

Depending on the financing schedule of the company four different DCF methods are distinguished today. Since the underlying financing assumptions are different they do not need to arrive at the same value of the project or company:

• Equity-Approach
  • Flows to equity approach (FTE)
• Entity-Approach:
  • Adjusted present value approach (APV)
  • Weighted average cost of capital approach (WACC)
  • Total cash flow approach (TCF)

[edit] See also

• Cost of capital
• Capital budgeting
• Economic value added
• Net present value
• Valuation using discounted cash flows
• Time Value of Money

[edit] External links

• Disk Lectures, Discounted Cash Flow audio lecture with slideshow
• Monography about DCF including some lectures on DCF
• Great Moments in Financial Economics
• The Theory of Interest at the Library of Economics and Liberty.
• Foolish Use of DCF

[edit] Literature

• Tom Copeland, Tim Koller, Jack Murrin: Valuation. J. Wiley & Sons, 2nd edition, 1998.

This is a book for practioneers.

• Lutz Kruschwitz, Andreas Loeffler: Discounted Cash Flow.J. Wiley & Sons, 2006.

This is a book for scientists.