Discounted cash flow analysis focuses upon the initial capital required to start and finish a given project. This includes any potential revenue, maintenance, required materials, and other associated costs.
The initial outflow of capital is considered expenditure, whereas potential cash flows are reflected back to the current date.
In short, this gives a window into the potential “earnings” of the future. This offers an investor’s perspective and insight into the (potential) monetary value of a given project, as it relates to their current circumstance.
Under the DCF method, the opportunity cost is itself considered an immediate loss in pursuit of future gain.
All of this serves to direct a consideration of the present value. The general rule for any project is that it must be profitable in nature. Any costs incurred must pave the way for generous future earnings that far outstrip the initial payments made.
If the future earning potential does not at least pay for the initial costs incurred, then it is not worthy of capital budgeting.
Cost of Capital
The cost of capital refers to borrowed money that was lent to the company. This means that any project which uses cost of capital (a lender) to finance its projects, must also consider the added cost of interest and external capital on outstanding loans.
The project must now not only account for general costs and upkeep, but also the terms of the loan itself. It must pay for all of these with its future earnings. Ideally, it will also prove highly profitable, exceeding performance far beyond these initial terms.
Publicly traded companies use the cost of capital as an important instrument in their operations. The raising of money through stock options allows a company to tap into its own equity. It can then leverage this financing into desirable projects that will create further value for existing shareholders.
A company may also choose debt instead of equity. This means it would pursue bonds or a bank credit, rather than publicly traded shares to finance its project(s).
All of these financial instruments would represent the cost of capital. These are financially potent methods for obtaining additional funding in the pursuit of new projects and infrastructure.