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.