Question

Discuss the advantages and disadvantages of the discounted cash flow model.

Answer 1

Discounted cash flow is a model wherein the present value of all the future cash inflow is calculated by discounting it using rate which is equal to cost of capital of that company. Basically, the purpose is to calculate if the investment in a particular given project is viable or not. Say, suppose-we invest $1300 in a project in the year 2012 and get only one inflow of $1500 after 3 years i.e at 2015. So, the present value of $1500 in the year 2012$, is figured out and compared using Discounted cash flow technique to check if the project/investment is good to go.

Advantages of Discounted Cash flow model are:-

1) It is considered as one of the best method to decide the viability of any investment, i.e if the net present value is positive, the investment will make money and if the net present value is negative, the project is not good to invest.

2) This method takes into account the time value of money which is the most important factor to invest money for long term purpose/project.

3) It helps to compare the cost incurred if the amount is borrowed and return on investment from the project.

4) As the time factor is considered while calculation, this in turn automatically take into consideration the risk involved during the tenure of investment, thereby reducing the uncertainty of what is expected to what is actually projected.

5) It further takes into account the gap in time in which the investment generates inflows.

Disadvantages of Discounted Cashflows:-

1) Calculation involves estimating the economic life of the  project which is uncertain.

2) The calculation of discounted cash flow is critical.

3) The inflows based on which the calculations are made are based on estimation, which again may be inaccurate or at times go unrealistic.

4) The interest rate used for discounting may not be near to actual giving absurd result.

Considering the above pros and cons, it is advisable to check the viability of the project using more than one method, instead of just relying on DCF model.