Discounted Cash Flow - DCF

A group of project-evaluation (q.v.) techniques in each of which all costs and benefits attributable to the project are discounted back at a given rate of interest to a single point in time.

BSI definition (21020) - A method relating future cash inflows and outflows over the life of a project or operation to a standard value (usually present value) using discount rates based on compound interest. NB Choice and evaluation of competing solutions should take account of net present value and changing price levels.

Explanation and illustration:

In the majority of capital projects, capital is initially invested to be followed over time by a stream of income and expenses (or more strictly cash inflows and outflows). The surplus of income over expenses is sufficient to pay for the investment (depreciation) and to provide a profit. If we regard the initial capital expense as occurring at the beginning of year one, net the income and expenses and regard the net income as arising at the end of each year, we could have a situation like this:

The project yields $20,000, i.e. $10,000 for the capital repayment and $10,000 for profit. Conventional means of project evaluation would not differentiate between the above scheme and also the following alternatives:

But you cannot afford to ignore the time value of money, for example, alternative bullet point 4 is much better than alternative bullet point 3. To overcome this difficulty we convert the cashflows to their equivalent at a single point in time, using a specified rate of interest.

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