Discounting future cashflow
Using discounts to compare the value of cashflows received at different times.
As a rule, money now is better than money in the future. There are two key reasons:
- Money has a time value. If you have money now, you can use it - for example, by putting it on deposit. Conversely, if you want money now but will only get it in the future, you would have to pay to borrow it.
- The further you look ahead, the greater the risks are. If you expect an investment to return 拢1,000 in a year's time, you may well be right. If you are looking ten years into the future, things might well have changed.
Discounting cashflow takes these concerns into account. It applies a discount rate to work out the present-day equivalent of a future cashflow.
For example, suppose that you expect to receive 拢100 in one year's time, and use a discount rate of 10%. If you put 拢90.91 on deposit at 10% for one year, at the end of the year you would have 拢100. In other words, the present value of that 拢100 can be calculated as 拢90.91.
Similar calculations can be used to work out the present value of cashflows you expect to receive further into the future. For example, suppose you expect to receive 拢100 in two years' time and use a discount rate of 10%. If you put 拢82.64 on deposit for two years at 10%, at the end of two years you would have 拢100. In other words, the present value of that 拢100 is 拢82.64.
You can use discounted cashflows to assess a potential investment.