How the Discount Rate Works in Cash Flow Analysis
The same term, discount rate, is used in discounted cash flow
analysis. DCF is used to estimate the value of an investment
based on its expected future cash flows. Based on the concept
of the time value of money, DCF analysis helps assess
the viability of a project or investment by calculating the
present value of expected future cash flows using a discount
rate.
Such an analysis begins with an estimate of the investment
that a proposed project will require. Then, the future returns it
is expected to generate are considered. Using the discount
rate, it is possible to calculate the current value of any future
cash flows. The project is considered viable if the net present
value (PV) is positive. If it is negative, the project isn't worth the
investment.
In this context of DCF analysis, the discount rate refers to the
interest rate used to determine the present value. For example,
$100 invested today in a savings scheme with a 10% interest
rate will grow to $110. In other words, $110, which is the future
value (FV), when discounted by the rate of 10%, is worth $100
(present value) as of today.
If one knows (or can reasonably predict) all such future cash
flows (like the future value of $110), then, using a particular
discount rate, the present value of such an investment can be
obtained.
What Is the Right Discount Rate to Use?
What is the appropriate discount rate to use for an investment
or a business project? While investing in standard assets, like
treasury bonds, the risk-free rate of return—generally
considered the interest rate on the three-month Treasury bill—
is often used as the discount rate.
On the other hand, if a business is assessing the viability of a
potential project, the weighted average cost of capital
(WACC) may be used as a discount rate. This is the average
cost the company pays for capital from borrowing or selling
equity.
In either case, the net present value of all cash flows should be
positive if the investment or project is to get the green light.
Types of Discounted Cash Flow
There are different types of discount rates that apply to various
investments of a business. What type is required depends on
the needs and demands of investors and the company itself.
Here are the most common:
Cost of Debt: Companies must take on debt to finance
their operations and keep the business running. The
interest rate they pay on this debt is known as the cost of
debt.
Cost of Equity: The cost of equity is the rate corporations
use to pay their shareholders. Investors expect a specific
rate of return in exchange for taking on the risk of
investing in a company.
Hurdle Rate: The minimum rate of return on a certain
investment or undertaking is known as the hurdle rate.
This allows them to make important decisions on whether
the venture is a good fit.
Risk-Free Rate: The risk-free rate is the interest rate that
comes with an investment or business venture with no
risk.
Weighted Average Cost of Capital: This is the rate of
return that investors expect for their capital. Investors can
include equity shareholders and bondholders.
Calculating the Discount Rate
To calculate the discount rate, use the following formula:
1/n
DR = ( FV ÷ PV ) -1
Where:
FV = Future value of cash flow
PV = Present value
(n) = Number of years until the FV
Here's an example to show how the discount rate works. Let's
say you want to determine the discount rate on a certain
investment using the following variables:
Future Value $5,000
Present Value $3,500
Number of 10
Years
Now, let's use the formula above to determine the discount
rate. For the fractional exponent, you can convert it to a
decimal ( 1 ÷ 10 ):
DR = ( FV ÷ PV ) 1/n - 1
1/10
DR = ( $5,000 ÷ $3,500 ) -1
DR = $1.42857 0.1 - 1
DR = 1.03631 - 1
DR = 0.03631
So, in this case, the discount rate is 3.631%.
What Effect Does a Higher Discount Rate Have on the Time
Value of Money?
The discount rate reduces future cash flows, so the higher the
discount rate, the lower the present value of the future cash
flows. A lower discount rate leads to a higher present value. As
this implies, when the discount rate is higher, money in the
future will be worth less than it is today—meaning it will have
less purchasing power.
How Is Discounted Cash Flow Calculated?
There are three steps to calculating the DCF of an investment:
Forecast the expected cash flows from the investment.
Select an appropriate discount rate.
Discount the forecasted cash flows back to the present
using a financial calculator, a spreadsheet, or a manual
calculation.
How Do You Choose the Appropriate Discount Rate?
The discount rate used depends on the type of analysis
undertaken. When considering an investment, the investor
should use the opportunity cost of putting their money to work
elsewhere as an appropriate discount rate. That is the rate of
return that the investor could earn in the marketplace on an
investment of comparable size and risk.
A business can choose the most appropriate of several
discount rates. This might be an opportunity cost-based
discount rate, its weighted average cost of capital , or the
historical average returns of a similar project. In some cases,
using the risk-free rate may be most appropriate.
What Is Discounted Cash Flow (DCF)?
Discounted cash flow (DCF) refers to a valuation method that
estimates the value of an investment using its expected
future cash flows.
DCF analysis attempts to determine the value of an
investment today, based on projections of how much money
that investment will generate in the future.
It can help those considering whether to acquire a company or
buy securities. Discounted cash flow analysis can also assist
business owners and managers in making capital budgeting or
operating expenditures decisions.
KEY TAKEAWAYS
Discounted cash flow analysis helps to determine the
value of an investment based on its future cash flows.
The present value of expected future cash flows is arrived
at by using a projected discount rate.
If the DCF is higher than the current cost of the
investment, the opportunity could result in positive returns
and may be worthwhile.
Companies typically use the weighted average cost of
capital (WACC) for the discount rate because it accounts
for the rate of return expected by shareholders.
A disadvantage of DCF is its reliance on estimations of
future cash flows, which could prove inaccurate.
How Does Discounted Cash Flow (DCF) Work?
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 that you have
today is worth more than a dollar that you receive tomorrow
because it can be invested. As such, a DCF analysis is useful
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 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 cents
because you cannot transfer it to your savings account to earn
interest.
Discounted cash flow 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 the future cash flows of an investment or project are
greater than the value of the initial investment.
If the DCF value calculated is higher than the current cost of
the investment, the opportunity should be considered. If the
calculated value is lower than the cost, then it may not be a
good opportunity, or more research and analysis may be
needed before moving forward with it.
To conduct a DCF analysis, an investor must make estimates
about future cash flows and the ending value of the
investment, equipment, or other assets.
The investor must also determine an appropriate discount rate
for the DCF model, which will vary depending on the project or
investment under consideration. Factors such as the company
or investor's risk profile and the conditions of the capital
markets can affect the discount rate chosen.
If the investor cannot estimate future cash flows or the project
is very complex, DCF will not have much value and alternative
models should be employed.
For DCF analysis to be of value, estimates used in the
calculation must be as solid as possible. Badly estimated
future cash flows that are too high can result in an investment
that might not pay off enough in the future. Likewise, if future
cash flows are too low due to rough estimates, they can make
an investment appear too costly, which could result in missed
opportunities.
Discounted Cash Flow Formula
The formula for DCF is:
Example of DCF
When a company analyzes 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 to evaluate the DCF.
The WACC incorporates the average rate of return that
shareholders in the firm are expecting for the given year.
For example, say that your company wants to launch a project.
The company's WACC is 5%. That means that 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.
Cash Flow
YearCash Flow
1 $1 million
2 $1 million
3 $4 million
4 $4 million
5 $6 million
Using the DCF formula, the calculated discounted cash flows
for the project are as follows.
Discounted Cash Flow
Yea Cash FlowDiscounted Cash Flow (nearest $)
r
1 $1 million $952,381
2 $1 million $907,029
3 $4 million $3,455,350
4 $4 million $3,290,810
5 $6 million $4,701,157
Adding up all of the discounted cash flows results in a value of
$13,306,727. By subtracting the initial investment of $11 million
from that value, we get a net present value (NPV) of
$2,306,727.
The positive number of $2,306,727 indicates that the project
could generate a return higher than the initial cost—a positive
return on the investment. Therefore, the project may be worth
making.
If the project had cost $14 million, the NPV would have been -
$693,272. That would indicate that the project cost would be
more than the projected return. Thus, it might not be worth
making.
Dividend discount models, such as the Gordon Growth
Model (GGM) for valuing stocks, are other analysis examples
that use discounted cash flows.
Advantages and Disadvantages of DCF
Advantages
Discounted cash flow analysis can provide investors and
companies with an idea of whether a proposed investment is
worthwhile.
It is an analysis that can be applied to a variety of investments
and capital projects where future cash flows can be reasonably
estimated.
Its projections can be tweaked to provide different results for
various what-if scenarios. This can help users account for
different projections that might be possible.
Disadvantages
The major limitation of discounted cash flow analysis is that it
involves estimates, not actual figures. So the result of DCF is
also an estimate. That means that for DCF to be useful,
individual investors and companies must estimate a discount
rate and cash flows correctly.
Furthermore, future cash flows rely on a variety of factors, such
as market demand, the status of the economy, technology,
competition, and unforeseen threats or opportunities. These
can't be quantified exactly. Investors must understand this
inherent drawback for their decision-making.
DCF shouldn't necessarily be relied on exclusively even if solid
estimates can be made. Companies and investors should
consider other, known factors as well when sizing up an
investment opportunity. In addition, comparable company
analysis and precedent transactions are two other, common
valuation methods that might be used.
How Do You Calculate DCF?
Calculating the DCF involves three basic steps. One, forecast
the expected cash flows from the investment. Two, select a
discount rate, typically based on the cost of financing the
investment or the opportunity cost presented by alternative
investments. Three, discount the forecasted cash flows back to
the present day, using a financial calculator, a spreadsheet, or
a manual calculation.
What Is an Example of a DCF Calculation?
You have a discount rate of 10% and an investment
opportunity that would produce $100 per year for the following
three years. Your goal is to calculate the value today —the
present value—of this stream of future cash flows.
Since money in the future is worth less than money today, you
reduce the present value of each of these cash flows by your
10% discount rate. Specifically, the first year’s cash flow is
worth $90.91 today, the second year’s cash flow is worth
$82.64 today, and the third year’s cash flow is worth $75.13
today. Adding up these three cash flows, you conclude that the
DCF of the investment is $248.68.
Is Discounted Cash Flow the Same As Net Present Value
(NPV)?
No, it's not, although the two concepts are closely related. NPV
adds a fourth step to the DCF calculation process. After
forecasting the expected cash flows, selecting a discount rate,
discounting those cash flows, and totaling them, NPV then
deducts the upfront cost of the investment from the DCF. For
instance, if the cost of purchasing the investment in our above
example were $200, then the NPV of that investment would be
$248.68 minus $200, or $48.68.
The Bottom Line
Discounted cash flow is a valuation method that estimates the
value of an investment based on its expected future cash
flows. By using a DFC calculation, investors can estimate the
profit they could make with an investment (adjusted for the
time value of money). The value of expected future cash flows
is first calculated by using a projected discount rate. If the
discounted cash flow is higher than the current cost of the
investment, the investment opportunity could be worthwhile.
