Discounted Cash Flow Analysis

Abstract

This technical note outlines the principles and application of proper discounted cash flow (DCF) analysis in the context of evaluating business investment projects. The note provides several specific examples, emphasizes building intuition for DCF modeling, and reviews several common errors novices to the subject make in such analysis. Excerpt UVA-F-1728 Rev. Oct. 2, 2020 Discounted Cash Flow Analysis Business managers face a steady flow of business investment opportunities. These important investment decisions take many forms: an extension of an existing product, software to reduce production costs, or a machine purchase to improve product quality. With so many investment choices, managers quickly appreciate that some amount of rigor is required to discriminate between those opportunities that merit going ahead with the investment from those that do not. In making these sorts of decisions, astute managers consider the perspective of their investors. To that end, this note outlines principles and examples of proper discounted cash flow (DCF) analysis in the context of evaluating business investment projects. The fundamental premise of the DCF approach is that the value associated with a business investment is measured by the expected cash flow gains to investors above what they might expect to generate on their own with investments of similar risk. DCF analysis provides an important tool that allows managers to model the gains to investors associated with investment opportunities. DCF analysis seeks to precisely identify the present value of economic net benefits to business investors associated with an investment (the net present value, or NPV). By identifying the investment cash flows, the manager is able to identify the exact source of the value gains and losses to investors relative to a baseline of not making the investment at all. To provide context for the discussion, this note begins with the example of a capacity expansion decision for a crop-dusting business. An Investment Decision for Dusty Barnes . . .