Discounted cash flow computes the present value of future cash flows. The applicable principle is that a dollar today is worth more than a dollar tomorrow. The terminal value, representing the discounted value of all subsequent cash flows, is used after the terminal year. This is the point at which the asset's useful life ends or beyond which cash flow estimation becomes difficult.
Determine the projected cash flow for subsequent years. You can project future cash flow based on past years’ data or by using industry averages. Choose a discount rate based on the expected rate of return. You can use the company’s historical rates or use an estimate equal to the company’s current short-term borrowing rates plus a risk premium.
Calculate the present value of each future year's cash flow. Using algebraic notation, the equation is: CFt/(1 + r)^t, where CFt is the cash flow in year t and r is the discount rate. For example, if the cash flow next year (year one) is expected to be $100 and the discount rate is 5 percent, the present value is $95.24: 100/(1 + 0.05)^1. The total of these discounted cash flows is the present value of your cash flow.
Determine the terminal value of the asset. You can use the salvage (resale) value, which can simply be the book value of the asset in the terminal year. You can also assume a constant cash flow into perpetuity starting in the terminal year. Here, the terminal value equals the constant cash flow divided by the discount rate. For example, if the cash flow is constant at $10 per year and the discount rate is 5 percent, the terminal value is $200 (10 divided by 0.05).
Calculate the present value of the terminal value, which is also a future cash flow that must be discounted to the present. Using algebraic notation, this equals TV/(1 + r)^T, where TV is the terminal value in the terminal year, T, and r is the discount rate. To continue with the example, the present value is $156.71: 200/(1 + 0.05)^5].
Add the present value of the future cash flows and the terminal value to calculate the total net present value of the asset.
For cash flow growing at a constant annual rate, the discounted cash flow, using algebraic notation, equals CF/(r - g), where g is the constant growth rate of the cash flow (CF) and r is the discount rate. For example, if a $10 cash flow grows at a constant annual rate of 2 percent and the discount rate is 5 percent, the terminal value is about $333.30: 10/(0.05 - 0.02). The constant growth rate (g) must be less than the discount rate (r).