A popular mechanism of measuring the discounted value of the future cash flow:
| (1) | \mbox{DCF}_i = \frac{\mbox{CF}_{t_i}}{(1+r)^i} |
| (2) | \mbox{DCF} = \sum_{i=1}^n \mbox{DCF}_i = \frac{\mbox{CF}_1}{(1+r)} + \frac{\mbox{CF}_2}{(1+r)^2} + \frac{\mbox{CF}_3}{(1+r)^3} + ... |
where
n | total number of accounting periods |
|---|---|
i= 0, 1, 2, 3, ... | running number of accounting period (usually 1 year) |
r | discount rate |
\mbox{CF}_i | free cash flow generated during the i-th accounting period |
\mbox{DCF}_i | discounted free cash flow flow generated during the i-th accounting period |
The main idea of DCF is that value of cash today is higher than value of cash tomorrow because immediate cash can be invested in readily available low-risk investment market opportunities and assure a certain profit. The loss of the cash value is controlled by discount rate.
Investor normally would like to compare DCF
NPV dictates that commercial project should not only be just profitable but instead should be on par with or more profitable than easily available investment alternatives.
The corporate investment policy usually dictates that:
investment projects with negative NPV should be rejected
investment projects with higher NPV should have a financing priority over the projects with lower NPV
See also
[ Profitability Index (PI) ] [ Net Present Value (NPV) ]