How to Calculate Discounted Cash Flow? Formula & Examples

Calculating discounted cash flow (DCF) is an essential financial technique used to assess the value of an investment, project, or business. Determining the present value of future cash flows helps investors and businesses evaluate whether an investment is worthwhile, factoring in the time value of money and associated risks.

The DCF method is particularly useful in comparing investment opportunities and determining the potential return on capital. Long-term investments or projects' discounted cash flow can be determined by using the cumulative discounted cash flow, which sums the present values of all expected future cash flows over multiple periods, providing a more comprehensive view of an investment's total value.

What is Discounted Cash Flow?

Discounted Cash Flow (DCF) is a financial method used to determine the value of an investment or asset by calculating the present value of its expected future cash flows, adjusted for the time value of money and risk.

Discounted Cash Flow Formula

Calculating the discounted cash flow requires following a simple formula, which discounts future cash flows back to their present value.

The formula for Discounted Cash Flow (DCF) is:

$DCF=\frac{CF}{(1+r{)}^n}$

CF:​ Cash flows for a period. 

(r): This is the discount rate.

(n): This is the number of periods (years).

How to Calculate Discounted Cash Flow

The discounted cash flow method is a widely used financial valuation technique to assess the value of an investment, business, or project. It calculates the present value of expected future cash flows by considering the time value of money and the associated risks. By discounting future cash flows to their current value, DCF provides a way to determine whether an investment is worthwhile. Here are the steps to calculate DCF:

1- Identify Future Cash Flows

Estimate the expected future cash inflows (revenues or returns) and outflows (costs or expenses) for each time period, typically broken down annually or quarterly. These should be realistic projections based on the nature of the investment or project.

2- Determine the Discount Rate

Choose an appropriate discount rate that reflects both the time value of money and the specific risks associated with the cash flows. This could be based on the required rate of return, the cost of capital, or a rate that reflects the investment's risk profile and opportunity costs.

3- Calculate the Present Value of Each Cash Flow

For each future cash flow, use the formula to discount it to its present value:

$Present Value of Cash Flow=\frac{Cash Flow at Tim{e}^n}{(1+Discount Rate{)}^n}$

Apply this for each period (e.g., year 1, year 2, etc.).

4- Sum the Present Values of All Cash Flows

Add up the present values of all individual future cash flows to obtain the total present value of the expected cash inflows and outflows. This total represents the overall value of the investment or project based on discounted future cash flows.

5- Interpret the Result

The result is the total discounted cash flow, representing the present value of all future cash flows. Compare this total value to the current cost or market price of the investment to determine if the investment is attractive. If the DCF is higher than the investment cost, it may be considered a good investment.

Read Also: Explain Cash Flow Statements: Importance and How to Use

Example of Calculating Discounted Cash Flow

If the expected cash flow from an investment is $10,000 over the next year, and the discount rate is 8%, what is the discounted cash flow of the investment?

First, identify the future cash flow and discount rate:

Cash Flow (CF): $10,000

Discount Rate (r): 8% (or 0.08)

Number of periods (years) (n): 1 year

Following the DCF formula, here is the calculation of the discounted cash flow of the investment:

$DCF=\frac{CF}{(1+r{)}^n}$

$DCF=\frac{\mathrm{10,000}}{(1+0.08{)}^1}=\mathrm{9,259.26}$

Result

The Discounted Cash Flow (DCF) for the $10,000 cash flow expected in one year with an 8% discount rate is $9,259.26. By comparing the present value of future cash flows to the cost of the investment, we’ll find that the result indicates that the investment is financially worthwhile.

Read Also: What is The Net Cash Flow Formula: Calculating & Examples

How to Calculate Cumulative Discounted Cash Flow 

Cumulative discounted cash flow is the sum of discounted cash flows for each period over multiple years. Each cash flow is discounted to present value and then added together.

Example 

Suppose you're considering an investment that is expected to generate the following cash flows over the next 3 years:

1. Year 1: $10,000
2. Year 2: $12,000
3. Year 3: $15,000

 The discount rate is 8% (0.08).

Steps to Calculate DCF:

1- Identify Future Cash Flows

Year 1: $10,000

Year 2: $12,000

Year 3: $15,000

2- Determine the Discount Rate

The discount rate is given as 8%, or 0.08.

3- Calculate the Present Value of Each Cash Flow

For each future cash flow, apply the DCF formula:

$PV=\frac{C{F}_1}{(1+r{)}^1}+\frac{C{F}_2}{(1+r{)}^2}+\frac{C{F}_3}{(1+r{)}^3}$

$PV=\frac{\mathrm{10,000}}{(1+0.08{)}^1}+\frac{\mathrm{12,000}}{(1+0.08{)}^2}+\frac{\mathrm{15,000}}{(1+0.08{)}^3}$

 4- Sum the Present Values of All Cash Flows

Now, add the present values of all three cash flows:

DCF = 9,259.26 + 10,290.02 + 11,906.81 = 31,456.09 

5- Interpret the Result

The total DCF is $31,456.09. This is the present value of all future cash flows from the investment, discounted at 8%. If the current cost of the investment is less than $31,456.09, it could be considered a good investment, assuming other factors are favorable.

Streamline Calculating Discounted Cash Flow

Enerpize online accounting software can streamline the calculation of discounted cash flow by automating key aspects of the process. It helps by generating accurate cash flow projections based on entered financial data from the cash flow statement, which is crucial for DCF analysis. Users can input different discount rates, such as the required rates of return, and Enerpize will automatically discount future cash flows to their present value, reducing manual calculations and minimizing the risk of errors.

Additionally, Enerpize simplifies the reporting of DCF results, presenting projected cash flows, present values, and overall enterprise value in an easy-to-understand format for stakeholders. Its audit trail and record-keeping features ensure transparency and accountability in the DCF process, allowing for verifiable and reliable analysis. By leveraging Enerpize's automated tools, businesses can efficiently and accurately perform DCF calculations, ultimately enhancing decision-making and financial planning.