Question

when we talk about discounting future cash flows, what exactly does that mean? what is the purpose of discounting cash flows?

Answer 1

Discounting a future cash flow means bringing it to its present value,ie.time value is attached to that particular cash inflow or outflow ,to analyse its value in the present value,ie. Timt t=0.

A cash flow ,like deposit in a bank, compounds itself , at a particular rate of interest per compounding period-- so natuarlly, it is worth more , say after 4 years.

On the reverse, ie, a cash inflow of $ 8000 is expected to occur at end of 4 yrs., is discounted to its present value , today, ie. t=0

To calculate the present value , we divide the cash flow by (1+discount rate used)^No.of yrs.

Here, the discount rate used is almost always the borrowing rate or cost of the funds acquired to run the business ,in general, or this project ,in particular.

When using general discount rates, the firm uses a weighted average cost of both the internal &outside capital , ie. Both equity & debt funds.

This is the same as the formula for compound interest , A=P*(1+i)^n

To know A or the future value we compound the P,Principal at rate,r=I , for n years

Similarly, to know P, or the initial Principal,we discount the amount at future time t , with the same n yrs.

where, i= the bank interest rate /period.

Purpose of discounting cash flows:

1. To know the current worth , for comparison &easy decision making .

2.To bring all cash flows , occuring at different time periods, in a project, to a common time-frame,t=0, for accuracy in analysis.

3.To give time value to the cash flows.

4. To safeguard against wrong decision-making such as both selection of the wromg project or rejection of the correct project.