Learn how to use discounted cash flow (DCF) to evaluate and select long-term investments for your business. Discover the advantages and limitations of DCF.

While considering for a project decision, company should also be able to relatively check their acceptable levels of returns, the risks associated with accepting the project and the relevant options and alternatives of the same capital. DCF technique is only a tool for quantifying future value of cash flow and does not constitute an ultimate outcome. Certain conditions, like market, environmental, social, political and other external factors should also be considered.

How do you use discounted cash flow in capital budgeting?

Capital budgeting is the process of evaluating and selecting long-term investments that align with the goals and strategy of a business. One of the most common and useful methods of capital budgeting is discounted cash flow (DCF), which estimates the present value of the future cash flows generated by a project or asset. In this article, you will learn how to use DCF in capital budgeting and what are its advantages and limitations.

1 What is discounted cash flow?

Discounted cash flow is a valuation technique that applies a discount rate to the expected cash flows of a project or asset over a certain period of time. The discount rate reflects the opportunity cost of capital, or the minimum return that an investor requires to invest in a project or asset. By discounting the future cash flows, DCF accounts for the time value of money, which means that a dollar today is worth more than a dollar in the future.

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Chad Myko Bayon-on, CPA, CMA, CSCA, CIA

Strategy | Execution | Finance Leadership | Governance| Risk Management | Internal Control | Fractional CFO | ESG Reporting | Chairman and Co-Founder at MB&A CPAs
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Future is uncertain and cash you are expecting to receive in the future is not the same cash value if it was received today. Since there is a lot of way for you to use cash in order for it to grow, the same cash in the future is the result of it ways, thus this discounted cash flow method arises. This shows the future cash flow value if it was acquired today discounted using the rate growth of opportunity.

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2 How to calculate discounted cash flow?

The discounted cash flow formula can be used to calculate the present value of a project or asset. This formula is DCF = CF1 / (1 + r) + CF2 / (1 + r)^2 + ... + CFn / (1 + r)^n, where DCF is the discounted cash flow, CF1, CF2, ..., CFn are the cash flows in each period (usually one year), r is the discount rate or the required rate of return, and n is the number of periods or the duration of the project or asset. To apply this formula, you'll need to estimate both the cash flows and discount rate for your project or asset. Cash flows should include initial investment, operating cash inflows and outflows, as well as the terminal value or salvage value at the end of its life. The discount rate should take into account risk and uncertainty of the project or asset, as well as market conditions and cost of capital.

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3 How to use discounted cash flow in capital budgeting?

Discounted cash flow can help you make informed decisions about capital budgeting by comparing the present value of the project or asset with its cost. If the DCF is higher than the cost, the project or asset is profitable and worth investing in. If the DCF is lower than the cost, the project or asset is unprofitable and should be rejected. You can also use DCF to rank multiple projects or assets based on their net present value (NPV), which is the difference between the DCF and the cost. The higher the NPV, the more attractive the project or asset is.

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Chad Myko Bayon-on, CPA, CMA, CSCA, CIA

Strategy | Execution | Finance Leadership | Governance| Risk Management | Internal Control | Fractional CFO | ESG Reporting | Chairman and Co-Founder at MB&A CPAs
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Decisions whether the project is worth investing or not is one of the key usage of DCF technique, it gives you a quantifiable result of whether the benefit youâ€™ll be able to utilize your capital with is within your acceptable levels and would be able to provide you some options for you venture it with.

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4 What are the advantages of discounted cash flow?

Discounted cash flow is a beneficial capital budgeting method, as it takes into account the time value of money for long-term investments. Additionally, it accounts for the risk and uncertainty of future cash flows by applying a discount rate. Furthermore, it focuses on cash flows instead of accounting profits, which can be manipulated or distorted. Finally, discounted cash flow is flexible and adaptable to different scenarios and assumptions.

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5 What are the limitations of discounted cash flow?

Discounted cash flow as a capital budgeting method has some limitations, such as requiring a lot of estimates and projections, which can be inaccurate or biased. It is also sensitive to the choice of the discount rate, which can have a significant effect on the DCF and the NPV. Additionally, this method may not capture the intangible benefits or costs of a project or asset, such as its strategic value or environmental impact. Furthermore, it may not account for changes in the market conditions or competitive environment over time.

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Chad Myko Bayon-on, CPA, CMA, CSCA, CIA

Strategy | Execution | Finance Leadership | Governance| Risk Management | Internal Control | Fractional CFO | ESG Reporting | Chairman and Co-Founder at MB&A CPAs
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Discounted cash flow just like other projection tool doesnâ€™t show a certainty of the future, environmental, social and market conditions. The rate used for the discounting may be biased and may not reflect the actual future benefit. In decision, a positive NPV does not mean that it is really a right choice to go with the project, it should also be able to consider the acceptable level of return a company is willing to take a risk with.

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6 Hereâ€™s what else to consider

This is a space to share examples, stories, or insights that donâ€™t fit into any of the previous sections. What else would you like to add?

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Chad Myko Bayon-on, CPA, CMA, CSCA, CIA

Strategy | Execution | Finance Leadership | Governance| Risk Management | Internal Control | Fractional CFO | ESG Reporting | Chairman and Co-Founder at MB&A CPAs
Report contribution
While considering for a project decision, company should also be able to relatively check their acceptable levels of returns, the risks associated with accepting the project and the relevant options and alternatives of the same capital. DCF technique is only a tool for quantifying future value of cash flow and does not constitute an ultimate outcome. Certain conditions, like market, environmental, social, political and other external factors should also be considered.

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Ryan Drews, DBA, CFPÂ®

Regional VP @ RWA Wealth Partners | Doctorate in Finance
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It is important to consider the existing portfolio of the company as well as the existing underlying risk in current projects. For example, if the company previously participated in higher risk capital projects, the next project may want to carry lower risk, even if the NPV is lower than other potential capital projects. Therefore, understanding the risk profile of capital projects serves as an additional variable when evaluating opportunities.

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How do you use discounted cash flow in capital budgeting?

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1 What is discounted cash flow?

2 How to calculate discounted cash flow?

3 How to use discounted cash flow in capital budgeting?

4 What are the advantages of discounted cash flow?

5 What are the limitations of discounted cash flow?

6 Hereâ€™s what else to consider

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