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 corresponding discount of the cash value over time is controlled by discount rate which is normally set along with Weighted Average Cost of Capital (WACC).
Investor normally would like to compare different investment opportunities with account of of how early money return and as such comparing DCF rather than FCF.
DCF is normally used to calculate Net Present Value (NPV) and compare investment projects.
See also
[ Profitability Index (PI) ] [ Net Present Value (NPV) ]