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    Discounting Cash Flows

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    Driton Bina
    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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    Discounting Cash Flows

    Uploaded by

    Driton Bina
    55 views5 pages
    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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    Discounting Cash Flows

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    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.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    55 views5 pages

    Discounting Cash Flows

    Uploaded by

    Driton Bina
    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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    Download as pdf or txt
    of 5

    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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