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sssfff · Jun 1, 2009, 04:10 PM

Why is it preferable, when comparing payment options, to sum the discounted cash flows instead of simply adding the cash payments?

morgaine300 · Jun 1, 2009, 09:51 PM

Because it's not worth the same thing today as it is in the future. If you could take $1000 right now, or you could take $1000 in 2 years (and let's assume you're not in any hurry for it), you would definitely want it now. $1000 in 2 years isn't going to be worth the same thing.

Here's an example with some real numbers. You have the option of taking $10,000 now, or taking $10,500 in 5 years. At first glance, does the $10,500 seem worth more? Well, what if you could take your money and invest it at 6% a year?

Normally this is done by figuring out the present value of all future values. That puts everything at a value today where you can compare them. So we would want the present value of the $10,500, at 6%, for 5 years. That is like saying: how much would you have to have today, invested at that amount for that time, in order to grow into the $10,500 5 years from now?

And that answer would be only $7846. You need $7846 today to make it grow into $10,500 five years from now. That means it's "worth" only $7846 right now.

So the $10,000 you could get today is definitely worth more than only having $7846 today.

"Discounting" the cash flow is meaning finding the present value.