Discounted Cash Flow

Before we discuss the DCF method we should understand the concept of present value of money.The basic idea behind discounting the future cash flows is that a rupee received later is not equal to a rupee received now.One of the cause for this is inflation.One rupee available now can be invested at interest and will be more than one rupee at future date.So we can not equate a rupee received in future with a rupee on hand.

Investment appraisal through the use of discounted cash flow method  requires a time preference rate to be  employed  in finding out  the present value of cash flow.The time preference rate used to discount the future expected cash flows is called as ‘ Discount Rate’  or  ‘ market rate of return on alternative investment.But the question regarding considering an appropriate discount rate.

A firm may naturally set a ‘target rate of return ‘ in appraising the investment proposals which ordinarily be not less than the cost of funds invested in a project.In addition ,it is prudent to believe that such a rate of return should be at least equal to the opportunity cost ,what can be earned if the funds were invested elsewhere with similar risk.

Higher the risk of the project being undertaken it is logical to expect higher rate of return to compensate the additional risk.Then the target rate of return or the required rate of return from the project could be the sum of risk free rate of return plus a ‘ risk premium’.

The present value to future receipts depends on two factors

1. The time of receipt
2. The  rate of discount- higher the rate of discount ,less is the present value.

D.C.F technique can be used in three ways to evaluate capital expenditure decisions

1. Net Present Value method
2. Desirability factor method
3. Internal Rate of Returns.

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