Discounted cash flow (D.C.F.)

By:

James Knight

James is a lead editor for Invezz, where he covers topics from across the financial world, from the stock… read more.

Updated: Aug 20, 2021

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A method of appraising investments based on the idea that the value to an individual or firm of a specific sum of money depends on precisely when it is to be received. Given the existence of interest rates and the possibilities ofborrowing and lending, it is always better to receive money earlier rather than later and to pay money later rather than earlier. For example, if the current annual interest rate is 10 per cent and I have £100 today, that could be worth £110 in one year’s time, £121 in two years’ time, £133,10 in three years’ time, and so on. It follows that if l am to receive £110 in one year’s time, that is worth only £1O0 held today, since that is the amount which would grow to £110 in one year’s time if I invested it at 10 per cent today. Since the value of a sum of money depends on when it is received, it follows that, in appraising investments, which typically yield profits over future time, we cannot simply add up the profits accruing at different points in time. It is necessary first to correct for the ‘time­value’ of money, and this is done by discounting, i.e. dividing by a suitable factor to find what the present worth or present value of a future sum really is. The result of this procedure will then be a discounted cash flow on the basis of which the true profitability of he investment can be assessed. There are several specific procedures based on the idea of discounted cash flow, such as internal rate of return or net present value.

Reference: The Penguin Dictionary of Economics, 3rd edt.