In this article, we’re going to explore what discounting cash flows is, including what it means, how it works, and why we should even bother doing it. Let’s get into it.
What is Discounting Cash Flows?
Firstly, what is “discounting cash flows”?
In a nutshell, it’s about expressing future cash flows in today’s terms.
Specifically, it’s about expressing future cash flows in today’s terms afterincorporating the time value of money, firm-specific risk, and market risk.
What is Discounting?
Discounting is just the process of estimating the value of future cash flows today.
Discounting allows us to establish how much future cash flows are worth in today’s terms.
Why Bother with Discounting Cash Flows?
Fundamentally, we discount cash flows because $1,000 today is worth more than $1,000 in the future.
And that is because money loses value over time. This fact is defined as the “time value of money”.
Time Value of Money
Consider an example. Imagine you have $1,000 in your wallet right now. Further imagine that you live in Cloud Cuckoo Land where the price of 1 banana is $1.
How many bananas can you buy right now?
You can buy 1,000 bananas with your $1,000 given each banana costs $1.
Now fast forward to a year later. The price of bananas have increased because of inflation. 1 banana now costs $1.05.
How many bananas can you buy now?
You can buy about 952 bananas with the same $1,000.
Thanks to inflation, you’re now worse off by 48 bananas.
You still have the same amount of money, but youcan’t do as much with it as you could before.
Put differently, yourmoney lost value over time.
That is the Time Value of Money.
We have a whole other article dedicated entirely to this concept, so you can learn more about the Time Value of Money here.
Discounting Cash Flows Process
If we think about discounting at the process level, ultimately it allows us to see how much future cash flows are worth to us today, given the time value of money, as well as other risks.
Consider the following cash flow stream:
We’re here, in Year 0 (the present, right here, right now).
And we’re going to get this future cash flow, 
in Year 1, then 
in Year 2, 
in Year 3, and so on and so forth all the way until Year N.
For simplicity, let’s assume that all of these cash flows are equal, in nominal terms.
So is the same as , which is the same as , and so on and so forth.
But of course, given the time value of money, we know that the first cash flow () will be worth more than the second cash flow () because money loses value over time.
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So we need to get this cash flow one , and we need to bring it back to Year 0 to see how much it’s worth to us right here right now.
Then we need to take the second cash flow, the cash flow we get in year two, and do the same thing – discount it back to year zero (today), to see how much it’s worth now.
And then we need to do the same thing for the third year, the fourth year and so on and so forth, until the nth year.
Ultimately we’re just taking these future cash flows and we’re discounting them back to the present.
Consider any future cash flow that you’ve got…
You’re going to take the future cash flow, and then incorporate these three different kinds of risks:
- firm-specific risk,
- market risk, and
- time value of money
And what you’re going to get then is the PV or the Present Value of Future Cash Flows.
The Discount Rate
And these three risks over here are incorporated in what we call the discount rate or 
.
This rate is the crucial ingredient for discounting future cash flows. If you don’t have this discount rate, you don’t have any sort of discounting.
So this is like the Holy grail of understanding discounting cash flows.
This rate, which is expressed as a percentage, incorporates all of the risks associated with a given project or firm.
Discount Rate Jargon Buster
There are, of course, a variety of other terms that are used to describe the discount rate, including:
- cost of capital
- the opportunity cost of capital
- hurdle rate
- required rate
- the required rate of return
- the weighted average cost of capital (WACC), under certain conditions
Some people call it 
because it refers to a sort of “capital”.
So any one of these is fine.
The key takeaway really is that they’re all essentially the discount rate.
The Present Value
Ultimately, we’re just taking these future cash flows and we’re discounting it back to the present. And in the general case, we do this by applying the formula for the Present Value (PV), which looks like this…
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So 
here refers to the Present Value of future cash flows. 
is the cash flow or the future cash flow occurring at time 
.
is your discount rate, aka hurdle rate, or cost of capital or required rate, whatever you want to call it.
It’s just the rate that discounts the future cash flows.
Let’s consider an example and see what this process actually looks like.
Discounting Cash Flows Example
Consider a cash flow stream where you get $7,500 every year for the next 5 years. Assume the appropriate discount rate is 10%.
How much are these cash flows worth today?
Although the cash flows are constant, meaning each cash flow is equal to the other…
Given the time value of money, the $7,500 that you get in Year 1 is actually worth more than the $7,500 you get in Year 2, which in turn is worth more than the $7,500you get in Year 3, 4, and so on and so forth.
In other words, the cash flows are constant and they’re equal in nominal terms, but they’re not equal when you consider them in real terms.And when you consider the other risks.
To really evaluate a project then, you’d need to discount these future cash flows.
What does that look like?
Well, it’s literally just a simple case of applying the equation for the Present Value.
