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Discounting Cash Flows

This document discusses discounted cash flow (DCF) analysis. It explains that cash flows expected at different times cannot be directly compared due to factors like risk, opportunity cost, and inflation. DCF analysis solves this by discounting expected cash flows to their present values using a discount rate. The discount rate accounts for things like the risk-free interest rate and risk premiums. Higher discount rates lead to lower present values.

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75 views5 pages

Discounting Cash Flows

This document discusses discounted cash flow (DCF) analysis. It explains that cash flows expected at different times cannot be directly compared due to factors like risk, opportunity cost, and inflation. DCF analysis solves this by discounting expected cash flows to their present values using a discount rate. The discount rate accounts for things like the risk-free interest rate and risk premiums. Higher discount rates lead to lower present values.

Uploaded by

Driton Bina
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Module 4

The Language and 



Tools of Financial Analysis
Discounting Cash Flows
(Not every dollar is equal)

Presenter: Paul Kofman

Discounted cash flow (DCF) analysis

Which of the following would you prefer?

$100 now or a promise of $100 a year from now?

Why?

There are at least three reasons:

1.  Expected inflation


2.  Risk
3.  Opportunity cost

We can’t directly compare cash flows that occur



at different points in time without thinking about
expected inflation, risk and opportunity cost!

1
DCF to Present value

The way that we account for the time value of


money is by systematically discounting future
cash flows.

Cash Flown
PV = n
(1 + r )
This results in future cash flows being re
expressed in terms of their present value
today!

As present values are recorded at the same


point in time (now) they can be compared
added together.

DCF to Present value


Example:
What is the present value of $100 expected in
one year’s time, assuming a discount rate of
5% p.a.?
Cash Flown $100
PV = n
= 1
= $95.24
(1 + r ) (1.05)
What is the intuition here?
What if the cash flow was expected in two
years’ time instead (rather than one)?
Cash Flown $100
PV = n
= 2
= $90.70
(1 + r ) (1.05)
Intuition?

2
Compounding to Future value

Instead of discounting future cash flows to


the present, we can also compound
present cash flows to the future.

What is the future value of $100 today in


two years’ time, assuming a discount rate
of 5% p.a.?
n 2
FVn = Cash Flow0 × (1 + r ) = $100 × (1.05 ) = $110.25

Why would we want to do that?


FVn n
PV = n
or FVn = PV × (1 + r )
(1 + r )

Choosing the discount rate

The discount rate r accounts for:

•  risk-free interest rate


•  rates of return on ‘similar’ risky
investments
•  or risk premia
•  opportunity cost
•  expected inflation

The greater the influence of these factors,


the greater the discount rate applied to the
future cash flows and the smaller the
present value.

3
DCF – Impact of the discount rate

Example continued:

Going back to our expectation of $100 in one year’s time – what


would happen to the PV if the discount rate was 15% p.a. instead of
5% p.a.?

Cash Flown $100


PV = n
= 1
= $86.96
(1 + r ) (1.15)
Intuition?

DCF – impact of the discount rate

4
Summary

•  Cash flows expected to occur at different


points in time aren’t directly comparable.

•  This is because of risk, opportunity cost


and expected inflation.

•  Discounting expected cash flows back to


their present values solves this problem.

•  Discounted Cash Flow (DCF) analysis is


the basis of the most popular project
evaluation methods.

Source List

•  Slide 8: Value of Cash Flows. © The University of Melbourne.

•  Additional overlay images / video sourced from: ©iStock.com/nmlfd; ©iStock.com/


IPGGutenbergUKLtd; ©iStock.com/kirkotinha; ©iStock.com/VladimirArkhipov.

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