Discounted cash flow
From Wikinfo
In finance, a discounted cash flow is the value of a cash flow adjusted for the time value of money. The nominal values of two cash flows in different time periods cannot be directly compared because the preference of most people for consumption sooner rather than later, and because of the opportunity cost of forgoing an interest earning investment. Establishing which interest rate or discount rate to use can sometimes prove to be a very complicated task.
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Math
In mathematical terms, discounted cash flow is expressed as
<math>DCF = \left (\frac{1}{(1+d)^n}\right) * CF </math>, where
- DCF is the discounted cash flow, or CF adjusted for the optortunity cost of future receipts;
- d is the discount rate, which is the risk factor (or the time value of money);
- n is the number of discounting periods used. I.e. if the receipts occur at the end of year 1, n will be equal to 1; at the end of year 2, 2?likewise, if the cash flow happens instantly, n becomes 0, rendering the expression an identity.
History
Promoted informally after the market crash of 1929, discounted cash flow was first formally articulated in John Burr Williams' 1938 text 'The Theory of Investment Value' at a time before auditing and public accounting were mandated by the SEC. As a result of the crash, investors were wary of relying on reported income, or indeed, any measures of value besides cash.
See also
- Adjusted present value
- Capital budgeting
- Economic value added
- Flow to equity
- Net present value
- Weighted average cost of capital
External Links
- Disk Lectures, Discounted Cash Flow audio lecture with slideshow
- Great Moments in Financial Economics
References
- Adapted from the Wikipedia article, "Discounted_cash_flow" http://en.wikipedia.org/wiki/Discounted_cash_flow, used under the GNU Free Documentation License
