Use Discounted Cash Flow Models to Make Capital Investment Decisions

Consider that companies will invest in projects that will generate more revenue for the business. This revenue is represented by a stream of future cash flows from the project. We introduced this topic in 3.3: Net Present Value, but it is worth reviewing the idea of future cash flows. When you have studied this section, you will be able to explain how a future stream of cash flows can be appropriately discounted to determine what the value is today.

Fundamentals of the Discounted Cash Flow Model

The discount cash flow model assigns a value to a business opportunity using time-value measurement tools. The model considers future cash flows of the project, discounts them back to present time, and compares the outcome to an expected rate of return. If the outcome exceeds the expected rate of return and initial investment cost, the company would consider the investment. If the outcome does not exceed the expected rate of return or the initial investment, the company may not consider investment. When considering the discounted cash flow process, the time value of money plays a major role.