Approaches to Calculating the Cost of Capital

A discounted cash flow analysis is a highly useful tool for calculating the net present value of a given product, process, asset, or organization.

The discounted cash flow approach is a valuation method investors and organizations can use to assess the net present value (NPV) of an asset, process, product, or the overall organization. NPV analyses using the discounted cash flow approach are widely used across various industries to decide which projects to invest in. They are also used as valuation devices for investors when looking at company performance, using past performance to project future performance.

The Discounted Cash Flow Formula

The discounted cash flow formula focuses on determining the relative time value of money of each projected cash flow (i.e., monthly, quarterly, annually, etc.), bringing each forecast of future value into present value terms. Just as in an NPV analysis, the ultimate end product will be the value of future profits (or losses) in today's terms. It's calculated as follows:

\({\displaystyle DCF={\frac {CF_{1}}{(1+r)^{1}}}+{\frac {CF_{2}}{(1+r)^{2}}}+\dotsb +{\frac {CF_{n}}{(1+r)^{n}}}}\)

In situations of multiple cash flows over multiple periods of time, it is necessary to create a summation that can incorporate variance in both variables:

\( DPV=∑_{t=0}^N\dfrac{FV_t}{(1+r)^t} \)

Sometimes, cash flows are considered continuous. In such scenarios, the appropriate adjustment to the equation is:

\( DPV = ∫_0^TFV(t)e^{−λt}dt \),

Inputs

When considering these formulas, you'll need to understand your inputs. The inputs for a discounted cash flow analysis are:

• DPV – The discounted present value of the future cash flow (FV), or FV, adjusted to compensate for the units of time in the future it will be received.
  
  
• FV – The nominal value of a cash flow amount in a future period (i.e., the amount of the cash flow before taking the time value of money into account).
  
  
• r – The interest rate or discount rate reflects two important information: the opportunity cost of foregoing other investments and the intrinsic risk of not receiving the projected cash flow.
  
  
• n – The time (in a given unit) before the future cash flow occurs. This is usually done annually but can be done monthly or quarterly. Keep in mind that r must be adjusted according to the time period!

Strategic Use

Like any projection, the most important thing to keep in mind as either investor or strategist is uncertainty. The primary purpose of a future cash flow analysis is to balance expectations to consider existing and future resources to make the optimal decision (from a profit perspective). As a result, determining 'r' (required rate of return due to opportunity cost and risk) is absolutely critical to the success of these calculations.

A Discounted Cash Flow Example This is a good example of a what a discounted cash flow analysis would look like on paper, particularly as a prospective investor. There's actually quite a bit more information here than you may strictly need to understand the calculation, but it's a great way to see how each piece of information fits together.