5.11 Discounting cashflows

This introductory section is focussed on the theory underlying discounting cashflows.

Discounted cashflow is based on the principle that the present value of $1.00 received in a year’s time is worth less than $1.00 received today.

The present value of $1.00 received in the future depends on when it is received and what discount rate is used.

  1. Example #1: $1.00 received in 12 months
    a. Using a discount rate of 5%, the present value is $0.9524 being $1.00 / 1.05
    b. Using a discount rate of 10%, the present value is $0.9091 being $1.00 / 1.10
  2. Example #2: $1.00 received in 24 months
    a. Using a discount rate of 5%, the present value is $0.9070 being $1.00 / (1.05×1.05)
    b. Using a discount rate of 10%, the present value is $0.8264 being $1.00 / (1.10×1.10)
  3. Example #3: $1.00 received in 36 months
    a. Using a discount rate of 5%, the present value is $0.8638 being $1.00 / (1.05×1.05×1.05)
    b. Using a discount rate of 10%, the present value is $0.7513 being $1.00 / (1.10×1.10×1.10)

It can thus be seen that $1.00 received at the end of every year for 3 years would have a present value of $2.7232 (0.9524+0.9070+0.8638) if discounted at 5% and $2.4868 (0.9091+0.8264+0.7513) if discounted at 10%.

Note that because we divide by 1 + the discount rate, the higher the discount rate, the lower the present value.

Refer to the discounted cashflow valuation method (next post) to see how this principle is applied in a business valuation.