A Project Is Expected To Produce Cash Flows Of Why Does Anyone Need Discounted Cash Flow?

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Why Does Anyone Need Discounted Cash Flow?

Mention a handful of financial calculation terms in a crowd, and you’re likely to get glazed eyes. Most people think that anything related to finance is too difficult or beyond their grasp. Quite the opposite is true.

Most of them, once explained to someone in common sense, are easily understood. In fact, many people calculate and think in many “finance terms” without even knowing they are doing it. Discounted cash flow DCF is one of them.

So what exactly is DCF analysis? It sounds complicated in mere terminology. In simple terms, it is calculated by taking the amount of cash generated by the business through sales or other means, and then taking into account the risk to generate that cash in the future. Most business owners are aware of this, although they may not refer to it as such. Business owners are always looking at the future and who the competition is.

In addition, they monitor what the current and future economic environment is expected to be and any differences in the cost of materials and labor. It took some finance guys to slap a fancy term on it.

Discounted Cash Flow (DCF) Analysis

Now that you know what a discounted cash flow (DCF) analysis is, what are the factors to calculate it? Usually the discounted cash flow is calculated based on the DCF project, which can then be summarized if a company wants to go that far. The three main components are free cash flow, the terminal value being calculated at the end of the free cash flow period, and the discount rate used on future projections to arrive at the present value. Here is a simple example, which omits the terminal value, but serves the purpose.

I will pay you $10,000 per year for the next 10 years or $25,000 today, which is the better deal? If there is a 100% chance I will be able to pay the annual payments in full, the annual payout is clearly worth more. But what if after 4 years, I’m less likely to pay you to 30%? This is why calculating the discounted cash flow DCF is important. It helps businesses invest wisely and helps banks and other investors value business aspects.

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