DISCOUNTED CASH FLOW

The total cash inflows over the life of the project should exceed all of the cash outflows. The cash flows take place over a specific period. The cash flows in the future have a different real value compared with today’s value. Therefore, a certain sum received at a date a year from now will have a value that is lower than that amount being received today. This is because of the concept that the money in hand today would have earned some interest in one year’s time. This concept is often referred to as the time value of money. For example, $100 today will be $110 in a year’s time if an interest rate of 10% is assumed. Therefore, $110 received in a year’s time will be worth only $100 today. It is generally accepted that the assumed interest rate deter-mines the present value of future cash flow. The value of $100 at an interest rate of10%, if interest is calculated every year, will be $121 in two years. Therefore, to have a present value of $100, the cash flow in two years is expected to be $121.The process of converting each future cash flow into its present value by using an assumed interest rate in this way is called discounting. The amount obtained by discounting is called the discounted cash flow. The discounted cash flow, since it incorporates the time value of money, is used in all cash flow analysis for evaluating capital projects.