 # 2.06 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.