Cash flows vary from project to project. In some cases cash flows
will occur evenly over time. There might be payments of similar amounts
that will be spread out over a time period at regular intervals. On the
other hand, there might be payments which are irregular and have no
pattern whatsoever. The challenge in corporate finance is to value these
different streams of cash flows. Here is how this is done:
Present Value of a Stream of Cash Flows
The present value of a stream of cash flows can be expressed as a
lump sum amount. This can be done only after all the expected future
receipts are converted to their present day values. The sum of these
values is then equal to the value of the expected stream of cash flows.
This is exactly how the value of a future stream of payments is derived
Nature of Cash Flows
The calculation of the present value of the future stream of money
depends upon the nature of the cash flows. If the cash flows are spread
out in an even pattern, shortcuts like annuities and perpetuities can be
used and the value of large streams can also be calculated very easily.
However, if the cash flows are uneven, individual payments have to be
discounted to their present value and then all those payments need to be
added up.
Inflation Forecasts May Change Over Time
Now, there are many investments that go on for a period of 10 years,
15 years and so on. The inflation forecast does not remain the same over
such an extended period of time. In fact historically, the inflation
will change every time there is a change in the business cycle. Hence,
for investments over a long period of time, multiple inflation forecasts
may be required where different rates are used in different years.
Uncertainty Increases with Time
Moreover, in projects where cash flow goes on for multiple years, the
uncertainty also increases with increased time. It is a fundamental
rule in corporate finance that the farther the expected payments are,
the more uncertain they are. This is because over an extended period
there might be political, economic or social changes that might affect
the cash flows. Hence different rates may be used to discount the cash
flows in different years to get a more accurate picture.
Multiple Discount Rates
Analysts almost always use multiple discount rates to represent the
different uncertainties that cash flows in different years have inherent
in them. Moreover, the value of the future cash flows is highly
sensitive to discount rates. Hence, small changes in the discount rate
can bring about big changes in valuation. This, coupled with the fact
that discount rates are very difficult to predict in advance makes
investing an art rather than a science.
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