Discounted cash flow information and application
January 3, 2014
Financial management is a risky business - predictions of future performance are prone to the effects of an ever-changing economic environment. Discounting predicted cash flows is one method a financial manager can use to account for the risks associated with forecasting performance.
Discounting a cash flow is the term used to describe the process of adjusting the amount to take into account the time value of money.
To discount an amount, simply multiply by the time value factor, which can be determined using this formula: 1/(1+r)t. In this formula, r stands for the discount rate and t stands for the appropriate number of periods (usually number of years). The concept of discounting is closely related to the broad fields of financial risk management and capital budgeting.
The rate used to discount cash flows is a quantitative measure of risk and required return of an investment. A higher discount rate indicates higher expected risk or a higher expectation of investment performance. The discount rate is highly customizable - managers can adjust the rate to reflect the project’s relative risk, and they could even set higher rates for later years to reflect the uncertainty inherent in estimating cash flows far into the future.
We’ll next discuss why discounting is important, but for now, it is sufficient to understand that the rate should never be lower than the company’s required rate of return for investments or its weighted average cost of capital (WACC).
Decision makers cannot see the future to determine the exact cash flows from an investment. They can only make an educated guess based on expert economic forecasts, discussions with front line managers, and other uncertain estimation techniques. That uncertainty can introduce substantial risk into decisions about large investments. For instance, consider a new product line estimated to bring in $2 million a year for the next 10 years. What if a recession hits and causes demand for the product to plummet? Would the investment still be profitable if it only brings in $400,000 in years 3 and 4? Or what would happen if inflation is higher than expected?
Along with risk, upper management must take into account the opportunity cost of investing in a project. An investment that initially costs $100,000 and provides $105,000 of net income over five years makes no economic sense if the company could instead buy $100,000 in short-term Treasury bills and receive $110,000 in net income after 5 years.
We’ve already discussed how the discount rate is used to factor risk and desired return into financial management decisions - let’s look now at a specific method of using discounted cash flows to estimate the net profitability of an investment.