Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analyses use future free cash flow projections and discounts them, using a required annual rate, to arrive at present value estimates. A present value estimate is then used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.
Types of DCF Techniques:
There are mainly two types of DCF techniques viz… Net Present Value [NPV] and Internal Rate of Return [IRR].
(A) Net Present Value Techniques [NPV]:
Net Present Value may be defined as the excess of present value of project cash inflows [stream of benefits] over that of outflows [cash outlays]. The cash flows of a project are discounted at some desired rate of return, which is mostly equivalent to the cost of capital.
(B) Internal Rate of Return [IRR]:
The Internal Rate of Return may be defined as that rate of interest when used to discount the cash flows of an investment, reduce its NPV to zero. Or it is the
rate of discount, which equates the aggregate discounted benefits with aggregate discounted costs.
IRR is also called as ‘Discounted Cash Flow Method’ or ‘Yield Method’ or ‘Time Adjusted Rate of Return Method’. This method is used when the cost of investment and the annual cash inflows are known but the discount rate [rate of return] is not known and is to be calculated.