Question

Ori's marketing director suggests that it is incorrect to use the same discount rate each year for the investment in packaging as the early stages are riskier and should be discounted at a higher rate. Another board member disagrees, saying that more distant cashflow are riskier and should be discounted at a higher rate.
Discuss the validity of the views of the directors.

Answer 1

1 -

Here in the above Question one of the Director of a company is of the view that Casflows at the early stages are riskier and are to be discounted at Higher rate.

The other is a Board member who is of a view that more distant cashflows are riskier and are to be discounted at Higher rate.

2 -

In layman terms "Money receivable tomorrow is much safe than money receivable on Day-after-Tomorrow" because we don't know what will happen in long run.

We never Discount Spot or Zero period Cashflows because they don't carry any risk.

Similarly Cashflows receivable in early stages don't carry much risk; but with the increase of Time period the level of Risk also increases.

3 -   

Let us consider the basic principle's behind Time value of money.

We discount future period cashflows using a certain rate and arrive at the Present Value of such cashflows.

The Value of Future Cashflows are reduced by using Discounting because Future Cashflows are always subject to Risk.  The rate used to discount cashflows accounts for two major criteria - A. Inflation & B. Risk.

4 -

The Longer the Duration to Receive Cashflow the Greater is the Risk of default.

Funds are Blocked in case of better Projects or Prospects availability which is also Risk in Long run

In a way the above points stand themselves to proove why the Short term receipts are less Risky.

5 -

In conclusion we can say that Cashflows in Early stages are less risky compared to Distant Cashflows because with Longer term comes larger risks.

So, Distant Cashflows being highly risky are to be discounted at Higher Rate.