Corporate Finance Basics

How do I discount a cash flow?

There are a number of types of cash flows and ways to discount them. There are single cash flows and multiple cash flows, and simple interest; compound interest and continuous compound interest may be used to discount them. We can also use the current value of a cash flow to find the future value or use the future value to find the present value.

Let's start with one of the more common, the single cash flow. In order to find the PV (present value) or FV (future value) of a cash flow, we must have a discount rate. Examples of this rate are an interest rate or a required rate of return.

The following example demonstrates when to use this method to find a present value of a single cash flow with compounded interest:

If, for example, we are looking to invest in a utility stock. We know that the CAPM and the DVM are the best methods to use to value utility stocks, but this stock does not give a dividend this year. The stock, however, will give a dividend of .50 in the year 2001. We therefore must discount the dividend by our required rate of return for the stock. (9% for example)

PV= .5/(1+.09)2

PV= .42

Since the year 2001 is 2 years away, and we want the current value of the dividend, we square the sum of 1 plus our required rate of return.

Often, we want to put a present value on something that has more than one cash flow. An example of this would be valuing a project. If the project were to last forever and give equal cash flow streams that are uniformly spaced, it is called a perpetuity; and if this cash flow stream has a fixed number of payments it is called an annuity.

Why Discount a Cash Flow?

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This website was created in May 1999 byAlison Hirsch '01, and is maintained by Professor Satya Gabriel, of the Economics Department at Mount Holyoke College