Question

What is the essence of the discounted cash flow methods?

answer in your own words ^^

Answer 1

Discounted cash flows are generally used in capital budgeting i.e., Whether to invest in a particular asset or not.

The above question can be answered only if we compare the outflow for the asset and inflows from the asset.

The outflow for the asset would be the initial cost of asset spent.

The inflow from the asset is the annual benefits that would arise over its life time.

It is irrational to compare the future inflow with the present outflow as we know that one rupee received today is more valuable one rupee received tomorrow.

So to compare and decide whether it is worth buying an asset or investing in a project, discounted cash flow models are essential. They discount the future inflows to the present values using our required rate of return.

There are 4 ways of discounting cash flow methods. The methods depend on pattern of inflows into an entity.

Perpetual Cash flow: When benefits accrue perpetually.

Annuity cash flow: When benefits accrue for a fixed period with equal amount.

Single cash flow: When a single amount is received after a certain period of time.

Mutiple uneven Cash flow: When benefits accrue over a certain period of time with an unequal amount.

So the main essence of discounted cash flows lies in bringing future values to present terms and compare the cost spent and benefit received.