Discounted Cash Flow Model

Discounted Cash Flow Model (DCF) is a financial valuation method used to estimate the value of an investment based on its expected future Cash Flows. The DCF model calculates the present value of projected Cash Flows by applying a Discount Rate, which reflects the Opportunity Cost of Capital and risk associated with the investment. This method is widely used in various contexts, including corporate finance, investment analysis, and real estate valuation.

The formula for DCF is as follows:

DCF = ∑ (Cash Flow / (1 + r)^n)

where:

Example 1: A company expects to generate $100,000 in Cash Flow annually for the next five years. If the Discount Rate is 10%, the present value of these Cash Flows can be calculated as:

  • Year 1: $100,000 / (1 + 0.10)^1 = $90,909
  • Year 2: $100,000 / (1 + 0.10)^2 = $82,645
  • Year 3: $100,000 / (1 + 0.10)^3 = $75,131
  • Year 4: $100,000 / (1 + 0.10)^4 = $68,301
  • Year 5: $100,000 / (1 + 0.10)^5 = $62,092

Total DCF = $90,909 + $82,645 + $75,131 + $68,301 + $62,092 = $379,078

Example 2: In real estate, a property generates rental income of $50,000 per year for 10 years. If the Discount Rate is 8%, the present value of the Cash Flows would be calculated similarly over the ten years, resulting in a total DCF that reflects the property’s value based on its expected rental income.

Case Study: A tech startup plans to launch a new product. Analysts project Cash Flows of $200,000, $300,000, and $500,000 over the next three years, with a Discount Rate of 12%. The DCF calculation will help investors determine whether the startup’s potential Cash Flows justify the initial investment.