FIN435 • DCF Basics • Chapter 3 + Chapter 12
DCF Basics: From Free Cash Flow to Project Cash Flow to NPV
This page introduces the basic logic of discounted cash flow (DCF), from free cash flow and discounting
to project cash flow, NPV, Monte Carlo analysis, workbook screenshots, and the Chapter 12 case.
Page structure
- Part I (Chapter 3): DCF basics, FCF, discounting, terminal value, enterprise value, and equity value
- Part II (Chapter 12 case): project cash flow, NPV, workbook screenshots, Monte Carlo, files, and videos
Part I — Chapter 3: Basic DCF explanation
Discounted Cash Flow (DCF) is a valuation method based on one simple idea: an asset is worth the present value of the cash flows it will generate in the future.
Value = Present Value of Expected Future Cash Flows
Main idea: money received in the future is worth less than money received today,
so future cash flows must be discounted back to the present.
Key topics in this part
- What free cash flow (FCF) means
- Why FCF is used in valuation instead of accounting income
- How to discount cash flows using WACC
- How terminal value works
- How to move from enterprise value to equity value
Basic firm valuation flow
- Estimate future free cash flows.
- Discount those FCFs back to today.
- Add a terminal value if the firm continues beyond the forecast period.
- The result is enterprise value.
- Add cash and subtract debt to get equity value.
- Divide by shares outstanding to get value per share.
Key valuation equations
FCF = EBIT(1 − T) + Depreciation − CapEx − ΔNOWC
Enterprise Value = PV of forecast FCFs + PV of Terminal Value
Equity Value = Enterprise Value + Cash − Debt
Stock Price = Equity Value / Shares Outstanding
Why DCF matters
- It connects valuation directly to cash generation.
- It emphasizes growth, risk, and timing.
- It shows why valuation depends on assumptions as well as formulas.
DCF video — connect FCF to valuation
After free cash flow is understood, the next step is to see how DCF converts those future cash flows
into a value today.
- FCF measures how much cash a business generates.
- DCF measures what those future cash flows are worth today.
- WACC is used to discount firm-level cash flows.
- Terminal value captures value beyond the explicit forecast period.
Big picture
Forecast cash flows → Discount at WACC → Add terminal value → Get enterprise value → Move to equity value
DCF basics — what each input means
Main inputs in a DCF model
| Input | Meaning | Why it matters |
|---|---|---|
| Free Cash Flow (FCF) | Cash flow available to all capital providers | This is the core cash flow being valued. |
| WACC | Weighted average cost of capital | This is the discount rate for firm-level FCF. |
| Growth rate | Expected future increase in FCF | Growth assumptions strongly affect valuation. |
| Terminal value | Value beyond the explicit forecast horizon | Often a large part of total value. |
| Cash and debt | Non-operating cash and financing claims | Needed to move from enterprise value to equity value. |
| Shares outstanding | Total shares of stock | Used to convert equity value into value per share. |
Basic DCF workflow
- Start with a current or recent FCF value.
- Forecast FCF for several years.
- Choose a discount rate, usually WACC.
- Discount each forecast cash flow.
- Estimate terminal value.
- Add the PV of forecast cash flows and terminal value.
- Move from enterprise value to equity value.
- Divide by shares outstanding if estimating price per share.
Why each input matters
- FCF: measures real cash generation, not just accounting profit.
- WACC: reflects the required return for the firm’s investors.
- Growth: changes future cash flow size and often drives valuation differences.
- Terminal value: captures continuing value after the forecast period.
- Cash and debt: adjust operating value into shareholder value.
Important point
A DCF model is not just plugging numbers into a formula.
It is a way to organize thinking about cash flow, risk, and growth.
- Different assumptions can produce different values.
- That does not automatically make one model wrong.
- What matters is whether the assumptions are reasonable and clearly explained.
Page note
This page focuses on the DCF process and a Chapter 12 case application.
One-stage DCF — stable growth starts immediately
Use this when: the firm is already in a mature, stable-growth stage.
FCF1 = FCF0(1 + g)
Enterprise Value = FCF1 / (WACC − g)
Equity Value = Enterprise Value + Cash − Debt
Estimated Stock Price = Equity Value / Shares Outstanding
Main steps
- Start with the most recent FCF0.
- Choose a long-run growth rate g.
- Use WACC as the discount rate.
- Compute enterprise value with the growing perpetuity formula.
- Add cash and subtract debt.
- Divide by shares outstanding if a per-share value is needed.
Limitation: this model may undervalue a fast-growing firm if it assumes mature growth too early.
Two-stage DCF — growth first, maturity later
Use this when: the company can grow faster for several years before settling into stable growth.
Forecast FCF year by year during the high-growth period
PV of Stage 1 = Σ [FCFt / (1 + WACC)t]
Terminal Value at Year N = FCFN+1 / (WACC − gterminal)
Enterprise Value = PV of Stage 1 + PV of Terminal Value
Equity Value = Enterprise Value + Cash − Debt
Main steps
- Choose a high-growth rate for the first stage.
- Choose the number of high-growth years.
- Forecast FCF for each of those years.
- Discount each forecast FCF at WACC.
- Use a lower terminal growth rate after maturity.
- Compute terminal value, discount it, and move to equity value and price per share.
Main idea: two-stage DCF is often more realistic for firms that are still expanding significantly.
Why compare one-stage and two-stage models?
- A one-stage model is simpler and easier to use.
- A two-stage model better captures the idea that strong firms may grow faster before maturing.
- For younger or faster-growing firms, valuation differences often come more from growth assumptions than from small changes in WACC.
Useful comparison questions
- Which model fits the company better, and why?
- How sensitive is the estimate to the growth rate?
- How sensitive is the estimate to WACC?
- Why might intrinsic value differ from the observed market price?
DCF worksheet structure
This worksheet layout can be used for a company-specific DCF exercise.
| Input | Value | Source / explanation |
|---|---|---|
| Most recent FCF | __________ | Public FCF source |
| Forecast period | __________ | Number of years forecasted |
| Growth assumption(s) | __________ | Assumption with explanation |
| WACC | __________ | Discount rate used |
| Terminal growth rate | __________ | Long-run growth assumption |
| Enterprise value | __________ | DCF calculation |
| Cash | __________ | Balance sheet input |
| Debt | __________ | Balance sheet input |
| Equity value | __________ | Enterprise value + cash − debt |
| Shares outstanding | __________ | If needed for per-share value |
| Estimated price per share | __________ | Calculated value |
Mini DCF example — simple version
Purpose: a small example to show the logic of DCF without needing a real company.
Assume
- FCF in Year 1 = $100
- FCF in Year 2 = $110
- FCF in Year 3 = $121
- WACC = 10%
- Terminal growth after Year 3 = 3%
Discount the forecast cash flows
PV(Year 1 FCF) = 100 / 1.10
PV(Year 2 FCF) = 110 / 1.102
PV(Year 3 FCF) = 121 / 1.103
Terminal value at Year 3
TV3 = FCF4 / (WACC − g)
FCF4 = 121(1.03) = 124.63
TV3 = 124.63 / (0.10 − 0.03)
Main takeaway
- The forecast period captures the first few years directly.
- The terminal value captures all value after the explicit forecast horizon.
- Most DCF models are highly sensitive to the terminal growth rate and WACC.
⭐ Part II — Chapter 12 Case: Project Cash Flow, NPV, Workbook Screenshots, Monte Carlo, File, and Videos
This section contains the Chapter 12 case inputs, workbook screenshots, file, and video walkthroughs.
Case overview
- Project cash flow setup
- NPV, IRR, MIRR, PI, payback, and discounted payback
- Monte Carlo simulation
- Excel case file, workbook screenshots, and video walkthroughs
Workbook structure
- Tab 1: Inputs and assumptions
- Tab 2: Depreciation and operating cash flow
- Tab 3: NOWC, salvage, and total project cash flows
- Tab 4: NPV metrics and Monte Carlo output
Case information
Initial investment and operating assumptions
| Item | Value |
|---|---|
| Cost of new equipment | $500,000 |
| Shipping and installation | $40,000 |
| Required increase in NOWC at t = 0 | $30,000 |
| Project life | 4 years |
| Tax rate | 25% |
| Required return / WACC | 10% |
| Expected salvage value in Year 4 | $80,000 |
Operating cash flow setup
| Item | Value |
|---|---|
| Annual unit sales | 5,000 |
| Selling price per unit | $70 |
| Variable cost per unit | $42 |
| Annual fixed operating costs | $60,000 |
| Depreciation method | Straight-line |
| Depreciable basis | Equipment + shipping/installation |
| NOWC recovery | Recovered in final year |
Core formulas
OCF = (Sales − Operating Costs − Depreciation)(1 − T) + Depreciation
NPV = Σ [FCFt / (1 + r)t] − Initial Outlay
Final Year Cash Flow = OCF + After-Tax Salvage + Recovery of NOWC
Monte Carlo setup
- Select key uncertain inputs such as unit sales, selling price, variable cost, and salvage value.
- Assign distributions or ranges to those inputs.
- Run repeated simulations to generate a distribution of NPVs.
- Review average NPV, downside probability, and the spread of outcomes.
Part II workbook screenshots
These Excel snapshots match the Chapter 12 case build and show how the project cash flow model is organized step by step.
1. Depreciation schedule
Depreciable basis, MACRS depreciation rates, annual depreciation expense, and remaining book value.
2. Annual operating cash flow
Units, price, cost growth, sales, depreciation, taxes, NOPAT, and operating cash flow by year.
3. NOWC and after-tax salvage value
Required net operating working capital each year, annual investment in NOWC, and the after-tax salvage calculation.
4. Project cash flows, NPV, IRR, and MIRR
Initial cost, operating cash flow, NOWC cash flow, salvage cash flow, total project cash flow, and decision metrics.
5. Sensitivity analysis tables
Base-case NPV with sensitivity checks for incremental costs, first-year unit sales, and salvage value.
6. Profitability index, payback, and discounted payback
Present value of future cash flows, profitability index, cumulative cash flows, and discounted payback setup.
Part II files, screenshots, and videos
Case file
Chapter 12 case workbook for Spring 2026.
chapter12_case_questions_spring_2026.xlsx
Download Excel File