Corporate Finance Basics

WHY DISCOUNT CASH FLOWS?

Let's begin the discussion of the importance of discounting cash flows by asking a question. If you were offered $100,000 and could receive it now or in 10 years, when would you take it? Most likely you would say now. You already know that money received now is more valuable to you than money received in the future.

We discount cash flows so that we can see what the future value of a cash flow is, or if given a future cash flow, what its current value is. Why would we want to do this?

Here is an example: If you were looking to start a business, you would have initial costs to start the business, and once the business began running, cash flowing in. How do you know if the cash inflows have a greater value than your initial investment? How do you know what future money is worth to you now? You would have to discount these future cash flows to the present value in order to compare them to your initial costs and see which is greater.

Since there is an opportunity cost of delaying payment (for a number of reasons, i.e inflation), your answer to the $100,000 question is "now". Discounting cash flows allows us to see how much opportunity cost is connected with the delay in payment.

Discount a Cash Flow

Back to Main Page

Corporate Finance Page

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