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Try not to be overly optimistic about the potential cash an investment project can generate in the future. When you’re discounting cash flows, it’s best to use the most accurate information you can. For example, if you use a different discount rate than 2.25%, you will get a higher or lower result. This means that changing the value of any element of the formula could significantly change the results. If the sum was higher, you could see a higher return.īe aware that discounting cash flows and the formula are largely dependent on assumptions and estimations. That’s because you may see a lower rate of return than the 2.25% discount rate used since the sum of the discounted cash flows is lower than the initial investment. With an initial cost of $30,000, this may not be a good investment opportunity. In the above example, the investment is worth $28,076.71. The sum represents the value of the investment. This requires adding up the discounted cash flows. To help you make a more informed decision on whether to pursue the investment, you can use the Discounted Cash Flow analysis. This is important information to have because it gives you a better idea of how much money you may actually be getting back in return. And, as time goes on, the $6,000 loses more and more buying power. When you get the results, you’ll see that the $6,000 the project is generating each year in the future isn’t worth the same amount in today’s time. To discount the cash flows from the example above, plug the numbers into the formula: Using the example above, let’s say the discount rate is the federal funds rate of 2.25%. If the investment you’re looking at includes projected cash flows over a number of years, you can use the formula above to discount them. The n represents the year of the projected cash flow. In this formula, r represents the discount rate. When you know the projected cash flows for an investment, you can use a formula to discount them. By using the federal funds rate as your discount rate, you’re essentially saying that this is your required rate of return for investing. This is because if you were to put your money in a savings account, it would grow at the given interest rate.

Some may use a lower single-digit discount rate and others may use a discount rate of 10%.Ī good rule of thumb to follow is to use the federal funds rate as your discount rate. Generally speaking, a higher discount rate represents higher risk and a lower rate represents lower risk. There’s no definitive discount rate that you should use it’s dependent on your investment situation. When you choose a discount rate, it also represents the required rate of return for your investment.

In the example above, it’s estimated the investment will generate $6,000 a year for five years, but that could change and you may get less money. By using the money to make an investment, there’s no guarantee the project will generate the money estimated. You have that money to do what you want with it, such as putting it in a savings account to collect interest. The $30,000 you have on hand right now doesn’t change. The discount rate is used for two reasons: It tells you the required rate of return on your investment and it takes into consideration the amount of risk involved with the investment. To discount projected cash flows, you use a discount rate. Simply put, you’re finding out how much $6,000 a year from now is worth in today’s time. To find out if the project is a good investment opportunity, you would discount the future cash flows to find the present value of the money. In the example investment opportunity above, the buying power of the $6,000 generated in each year decreases as time goes on. The time value of money is the reason why you discount cash flows. That’s because of different factors, like the effect of rising inflation. The dollar you have in your wallet today has more buying power than a dollar a year from now. The money you have on hand today is worth more than the same amount of money in the future. But $6,000 a year from now isn’t worth as much as $6,000 today.ĭiscounting cash flows can help you make an informed investment decision and better understand what the projected income is worth in present time. Should you do it?Īt first glance, an investment opportunity generating $6,000 a year can seem attractive to you. The investment will cost you $30,000 and is estimated to generate $6,000 a year for the next five years. Your small business is growing and you have the opportunity to make an investment in your business.