George B. Baldwin
DISCOUNTED CASH FLOW stands for a modern and fast-spreading technique for the evaluation of investment proposals. The world of money and finance has understood DCF (without calling it that) for as long as compound interest has been with us, which is quite long. But a lot of businessmen and economists have discovered only within the past decade or so how useful and important this concept is.
The ordinary language of business treats the rate of profit as the ratio of (a) accounting profit in a representative year to (b) the amount of capital tied up in the enterprise, as measured by Net Fixed Assets or Net Fixed Assets plus inventories. It is a one-year figure, for some actual or representative year, after deducting allowances for taxes and for depreciation; both these items can be highly arbitrary. Furthermore, the ordinary one-year measure of profitability takes no account of the length of time that may separate the capital expenditures and the returns they eventually produce. The Discounted Cash Flow method can often give us a much better measure of a project’s profitability, for three main reasons:
DCF washes out year-to-year variations in profit and gives us a single valid figure for the whole life of the project.
DCF automatically takes into account the timing of cash payments and receipts, so that no one can neglect the importance of this factor.
DCF gets around the difficulty of interpreting what accountants mean by “profit” and gives us a simple, unambiguous definition based on project earnings over the entire life of a project.
All these points are well known to those already initiated into the mysteries of DCF. But others cannot hope to understand these claims for the method until they have gone back to “square one.” First one has to understand what a Cash Flow is, why and how to discount it, and then what one can do with a DCF once he has it.
The compound interest formula is (1.0+r)n; the discount-factor formula