What happens if the discount rate is too high in a DCF analysis?

When the discount rate is too high in a Discounted Cash Flow (DCF) analysis, the present value of future cash flows decreases. This occurs because the discount rate is used to convert future cash flows into their present value, reflecting the time value of money and the risk associated with those cash flows.

A higher discount rate means that future cash flows are being discounted more heavily. Essentially, the farther in the future cash flows are expected to occur, the more their present value is diminished by the higher rate. As a result, even if the future cash flows themselves remain unchanged, their value today diminishes, leading to a lower overall valuation of the project or investment being analyzed.

For instance, consider if you expect to receive $100 in five years. With a lower discount rate, the present value of that $100 would be higher. Conversely, applying a significantly high discount rate effectively reduces how much that future $100 is worth today.

This principle is central in financial decision-making, as it influences investment valuations and assessments of profitability. Therefore, determining an appropriate discount rate is crucial for accurate DCF analysis.