Capital Budgeting: Using Discounted Cash Flow (DCF) Analysis

Capital budgeting with discounted cash flows (DCF) allows you to value a project, based on the time value of money. In essence, you are discounting the value of future cash flows to determine if the value today makes the project worthwhile.

Equation Basics

The DCF equation is:

Discounted Present Value (DPV) = Future Value / (1 + interest rate)^ time period

The equation is used to allow you to determine the value today of a future cash flows. For example, if investing $100,000 today will result in a cash flow of $125,000 in two years. In order to make a fair judgment of whether the return is a good one, you will need to consider the cost of capital. If it will cost you 8% per year to borrow the money, the return is less attractive. Using the equation, you get $125,000 / (1 + 0.08) ^ 2 = 107,167.40. After you return the original $100,000, you will only earn $7,167.40. While this is not a great return, it is positive, so the project may worth consideration.

Drawback

The drawback to this method is that it assumes that the cost of capital, or the interest rate used will not vary. Another problem is that it assumes cash flow can be accurately projected. While you can make both of these factors variable, it makes the calculation cumbersome and increases the chances of error.