DCF is a preferred method for evaluating capital expenditures (and other investments) because DCF recognizes the time value of money. In other words, it recognizes that receiving $10,000 of cash today is more valuable than receiving $10,000 of cash in the future. Similarly, $10,000 cash receipt in Year 10 is less valuable than a $10,000 cash receipt in Year 7.
The recognition of the time value of money occurs by discounting the related future cash flows back to the time when cash is invested. (The date that the cash is invested is often referred to as the "present" or the very beginning of the investment's first year.)
The greater the time value of money, the greater will be the amount of the discount. The smaller the time value of money, the smaller the amount of the discount. In turn, a larger discount will mean a smaller present value. A smaller discount will result in a greater present value.
DCF is also useful for calculating the approximate market value of bonds payable, a product line, or entire companies.
To learn more, see the Related Topics listed below: