# Understanding the Discounted Cash Flow Method for Capital Budgeting

The discounted cash flow (DCF) method is a popular and effective tool used by businesses to evaluate the potential profitability of a capital investment. It takes into account the time value of money, meaning that money received in the future is worth less than money received today. This method is used to determine the present value of future cash flows generated by the investment.

When considering a capital investment, the DCF method helps businesses to determine the expected return on their investment. By discounting all future cash flows, businesses can calculate their net present value (NPV), which is the difference between the present value of the cash inflows and the present value of the cash outflows. If the NPV is positive, the investment is deemed a good one and should be pursued.

To use the DCF method, businesses must first estimate the cash flows that the investment will generate over its useful life. This includes all expected inflows and outflows, such as revenue, costs, taxes, and any other expenses associated with the investment. The cash flows should be estimated for each year of the investment’s useful life.

Once the cash flows are estimated, businesses must then determine the appropriate discount rate to use in the calculation. This rate should reflect the risk associated with the investment and should be higher than the rate of return that could be earned in alternative investments. The higher the risk associated with the investment, the higher the discount rate should be.

Once the cash flows and discount rate have been determined, businesses can calculate the NPV of the investment. This is done by discounting each of the cash flows at the appropriate rate and summing the discounted values. The NPV is then compared to the initial investment amount. If the NPV is positive, the investment should be pursued.

For example, a business is considering investing $1 million in a project that will generate cash flows of $200,000 per year for the next five years. The appropriate discount rate is 10%. The present value of the cash flows can be calculated as follows:

Year 1: $200,000 / (1 + 10%) = $181,818

Year 2: $200,000 / (1 + 10%)2 = $164,890

Year 3: $200,000 / (1 + 10%)3 = $149,275

Year 4: $200,000 / (1 + 10%)4 = $135,000

Year 5: $200,000 / (1 + 10%)5 = $122,097

The total present value of the cash flows is $843,080. The NPV of the investment is then calculated as $843,080 – $1 million = -$156,920. Since the NPV is negative, the business should not pursue this investment.

The DCF method is a powerful tool that businesses can use to evaluate the potential profitability of capital investments. By taking into account the time value of money, businesses can accurately assess the expected return on their investments and make informed decisions about whether or not to pursue them.