Discounting a Stream of Future Cash Flows

If we combine the learning from the previous three sections of this chapter we get to the meat of the method here: discounting a stream of future cash flows into a present value. The determination of what the cash flows are (not simply the revenue or profit from sales!!!) is very important and we will discuss this in detail in the next section. For now, let’s assume we know what the relevant cash flows are. Remember, the FREE spreadsheet is formated to do all your calculations!

I'll start the explanation of discounting by first discussing a more common and related process: compounding interest. The idea of compounding interest simply says that as time goes on and you're earning interest on invested money (like the dollar in the opportunity cost reason for present value methodology mentioned above) and on the interest earned on that invested money. Here is a simple example:

If you earn interest of 10% per year, compounded yearly, on a one dollar investment you will have $1.10 at the end of the first year. If you invest the dollar at the same 10% rate for two years, you will not have $1.20 but rather $1.21. The reason is compounding: the second year you had $1.10 invested since you earned 10% or $.10 the first year. Interest in the second year was based on the $1.10 and not the original $1.

Discounting is the same concept in reverse. You are bringing that value back in time from the end of second year $1.21 to a present value of $1.00. Discounting is simply the establishment of a future value in today's terms. Here is another example:

Above is a sample. Read the full chapter.

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