A popular mechanism of quantifying the discounted value of the future cash flow:
| (1) | \mbox{DCF}_i = \frac{\mbox{FCF}_{t_i}}{(1+r)^i} |
| (2) | \mbox{DCF} = \sum_{i=1}^n \mbox{DCF}_i = \frac{\mbox{FCF}_1}{(1+r)} + \frac{\mbox{CFF}_2}{(1+r)^2} + \frac{\mbox{FCF}_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{FCF}_i | free cash flow generated during the i-th accounting period |
\mbox{DCF}_i | discounted value of free cash flow generated during the i-th accounting period |
\mbox{DCF} | discounted value of total free cash flow flow generated over "n" accounting periods |
The main idea of DCF is that in Economics the value of cash today is higher than value of future cash because it is already in hand and can be invested in readily available low-risk investment market opportunities and assure a certain profit. While future cash may not happen at all or may be lower than returns from readily available low-risk investment.
The corresponding discount of the cash value over time is controlled by Discount Rate (usually denoted as
r) which is normally set along with Weighted Average Cost of Capital (WACC).
Investor normally would like to compare different investment opportunities and give early returns more weight and as such comparing DCF rather than FCF.
DCF is used to calculate Net Present Value (NPV) to prioritise investment projects.
See also
Economics / Investment / Financial Investment / Cash Discount
[ Profitability Index (PI) ] [ Net Present Value (NPV) ] [ Internal Rate of Return (IRR) ]