Financial Glossary
Discounted cash flow
Discounted Cash Flow (DCF) is a valuation method that estimates the present value of a business or asset by projecting future cash flows and discounting each back to today using a rate that reflects the time value of money and investment risk. Formula: DCF = sum of (CF_t / (1 + r)^t) for each period t, where CF_t is the expected cash flow in period t and r is the discount rate (typically weighted average cost of capital for business valuations). The intuition: a dollar received three years from now is worth less than a dollar today because of opportunity cost and inflation. A terminal value is usually added to capture cash flows beyond the explicit forecast period.
Problem & Application
A campground owner is evaluating whether to invest $500,000 in glamping infrastructure. Projected incremental annual free cash flows: Year 1: $80,000; Year 2: $110,000; Year 3: $130,000; Year 4: $150,000; Year 5: $150,000 plus a terminal value of $900,000 (sale or ongoing income stream). Using a 10% discount rate: PV of Year 1 = $72,727; Year 2 = $90,909; Year 3 = $97,673; Year 4 = $102,452; Year 5 = $93,138; terminal value PV = $558,827. Total DCF = $1,015,726. Net present value (NPV) = $1,015,726 - $500,000 = $515,726 -- a positive NPV indicates the investment creates value. Sensitivity analysis on the discount rate (8% vs. 12%) and terminal value assumptions is essential because small input changes produce large valuation swings, especially in the terminal value.
In Short
DCF is a fundamental valuation tool. Businesses must use realistic inputs and sensitivity analysis to ensure reliable results.
