A discounted cash flow or DCF model is a style of calculation linking streams of future money flows to lump sum amounts. Discounted cash flow models have a range of business-related applications, and are used extensively by economists, accountants, actuaries, engineers, business valuators, finance professionals, and others.
For example, a company may wish to finance a project if (and only if) the Internal Rate of Return exceeds 10% per year. The anticipated development costs for the project may be large for the initial year. On the other hand, significant revenues are anticipated for Year 2 onward. The company directors rely on a DCF model to help determine whether or not the project's Internal Rate of Return exceed their 10% threshold.
Discounted cash flow models also have important applications in everyday life that are often overlooked. For example, consider auto dealers who advertise low finance rates to prospective clients. From a car buyer's perspective, low finance rates are understood to be good, since they mean lower monthly payments. By using a DCF model, a buyer can determine the monetary value on the low finance rate offer.
Everyday use of a Discounted Cash Flow model would include (but would not be restricted to) the following:
- Mortgage Refinancing: For homeowners with a fixed-rate mortgage, refinancing often debts paying a penalty. A DCF model can be used to calculate whether the interest savings exceeded the penalty cost
- First-Time Home Ownership: First time home ownership involves many new costs, and can be intimidating to many of us. A DCF model can help by comparing long term home ownership costs against rental costs
- Lease or Own Vehicle: A DCF model can help car shoppers in their decision whether to buy or lease a vehicle
Examples of these and other everyday applications can be viewed at the author's website.
Through the above (and other) practical applications, Discounted Cash Flow models can assist all of us in achieving our personal financial goals.