Investment appraisal techniques
Discounting future cashflow
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 £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 £100 in one year's time, and use a discount rate of 10 per cent. If you put £90.91 on deposit at 10 per cent for one year, at the end of the year you would have £100. In other words, the present value of that £100 can be calculated as £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 £100 in two years' time and use a discount rate of 10 per cent. If you put £82.64 on deposit for two years at 10 per cent, at the end of two years you would have £100. In other words, the present value of that £100 is £82.64.
You can use discounted cashflows to assess a potential investment.