Fundamentals of Discounted Cash Flow

42 Pages Posted: 21 Oct 2008

See all articles by Robert S. Harris

Robert S. Harris

University of Virginia - Darden School of Business

Abstract

This note introduces the time value of money and the general discounted-cash-flow approach to valuation. It covers present value, future value, and effective interest rates, and includes specific examples.

Excerpt

UVA-F-0918

FUNDAMENTALS OF DISCOUNTED CASH FLOW

Most financial decisions involve risky benefits and costs that are spread out over time. When people buy stocks, they pay money today (the price of the stock) and expect benefits in the future (dividends plus a rising stock price). When financial managers consider purchasing a new piece of equipment, money is spent today and benefits (for example, cost savings) are expected in the future. Facing such decisions, we need some way of gauging whether the decisions are good ones. In terms of financial management, does the decision create value?

Getting estimates of value is a difficult task. In finance, one of the essential methods of obtaining such estimates is discounted cash flow. DCF assumes that the value of an asset depends not on its cost or its past usefulness, but on its future usefulness. For example, suppose you own a share of stock in IBM. Its value today depends on what dividend payments IBM may make in the future and on the price for which you can sell the stock—not on what you paid for the stock when you bought it. This value is obtained by taking the cash flows associated with the assets and penalizing them, or discounting them, if you have to wait for the cash or if you are uncertain about whether the cash will actually be there even if you wait. Thus, discounted cash flow is a way of evaluating future benefits in terms of time and risk.

Time Value of Money

This note will focus on the way discounted cash flow handles time. The key point to understanding the time value of money is that a dollar today is worth more than a dollar in the future because waiting for future dollars involves forgoing the opportunity to earn a rate of return. If, for example, I gave you $ 1.00 today and you could put it in the bank and earn 6 percent interest per year, at the end of a year you would have $ 1.06. As a result, a dollar today is able to become more than a dollar in one year because of the interest rate. In this case, the interest rate of 6 percent per year is the opportunity cost of waiting for future dollars—it is a return that you have to forgo if you choose to receive money in the future rather than to receive money today.

. . .

Keywords: present value, valuation, interest rates, discounted cash flow, cost of capital

Suggested Citation

Harris, Robert S., Fundamentals of Discounted Cash Flow. Darden Case No. UVA-F-0918, Available at SSRN: https://ssrn.com/abstract=909070

Robert S. Harris (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4823 (Phone)
434-924-4859 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/harris.htm

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
844
Abstract Views
2,408
rank
30,684
PlumX Metrics