Why is it important to discount future cash flows?

Answer 1

This is one of the great economic theories of the 20th century. The current worth of something is supposed to be equal to the discounted value of future cash flows. (You need to discount the cash flows because the value of money is time dependant, i.e. 100 dollars received in 20 years is not worth the same as that received now.)

While this theory continues to hold much credence, stock markets show time and again that the valuation of dstocks bears little or no relationship to the theoretical value calculated above. Hence while interesting the theory is of almost no use when looking at a stock's likely price!

S Marquet

http://www.southoffrancehotel.com

Answer 2

Another reason you might want to discount future cash flows is because of the uncertainty of making such predictions.

Lets suppose that I own a construction company whose business has been booming recently. If interest rates rise, I'm likely to see fewer people invest in building property, because it will cost them more money to borrow that money, and they might not want to borrow that money on such unfavorable terms. As a result, although my business was booming, suddenly, it might come to a screeching halt if everybody backs out of the construction projects they had originally hired me for. My future cash flow has gone from significantly positive to zero.

There is always a similar economic risk in other industries too. You can't guarantee that future cash flow will be the same as current cash flow, so it gets discounted due to that uncertainty.

Answer 3

Future cash flows are discounted in order to show the decrease in value of money over time. It is always better to have money sooner rather than later, you can always do something with it when you have it.
The common theory is to discount for Inflation although the truth is that the discounting of money does allow for inflation but that is not the whole picture and that other factors are taken into consideration aswell.