Discounted cash flow techniques

Discounted cash flow (DCF) techniques have become more accessible with the widespread use of computers and spreadsheets. The spread sheet software enables estimates of income, expenses and other cash flows such as capital outlays and resale or disposal value to be itemised period by period over the life of the investment opportunity. These are then aggregated period by period and discounted back to their present value at the investor’s required rate of return.

Judgement needs to be exercised in interpreting the results of discounted cash flow analyses. In particular, they are based on estimates of future cash flows and so lack the precision that a numerical outcome implies. Sensitivity analysis is a useful means of checking the robustness of the outcome of discounted cash flow analysis. It involves altering input line items one at a time to see how sensitive the answer is to alternative cash flow estimates. This also helps identify the items that can most threaten the viability of the proposed investment.