Discounted Cash Flow (DCF)
DCF is the fundamental means of economic evaluation of projects. It is widespread in practice and some class participants will be fully familiar with it. But experience shows that many in class are rusty on the concept and approach, or have never been introduced to DCF. The class therefore covers the essential concepts at the start of the class.
DCF has many advantages. It is transparent—it visibly presents assumptions, the levels of system inputs and outputs and the connections between them. It is broadly applicable to all sorts of situations – in particular step function changes in capabilities or inputs, and “black swan” events. It is easy to explain to decision-makers – the mathematics and concepts are simple to understand. Finally, it is a wide-spread common language among investors, bankers, and others valuing project proposals.
DCF runs on spreadsheets. Spreadsheets are also highly practical ways to present risks and uncertainties over time. They can cope with any kind of distribution of risk as well as “black swan” or Bernoulli events. This section therefore provides links to Excel boot-camp material that participants can consult to embed probabilities in spreadsheets efficiently.
The discount rate is key parameter in the use of DCF. It determines the results of any economic valuation. So, we need to understand where this parameter comes from and how experts go about determining it. The DCF discussion outlines the main issues to give you appropriate background.
As a practical matter, system managers and designers will not be asked – or allowed – to choose their discount rate: their organization, clients, or investors will specify the rate to use. Note that organizations commonly specify discount rate to 2 decimal points (for example 9.80%). Such figures suggest great accuracy – but empirical investigations indicate that such precision is not justified – and some organizations just use whole numbers (10%, say). Ultimately, organizations specify their discount rate to establish a common reference for their evaluations.
