The concept of discounting cash flows implies the process of bringing the value of transactions made at different times to a value that is relevant for the present. For example, for the sale of any enterprise, it is necessary to re-evaluate it, that is, to determine the cost taking into account the changing market conditions. The method of discounted cash flows is often used in transactions with investments. Indeed, in order to make a cost-effective investment, it is necessary to take into account any changes in the value of the asset.
It is worth noting that the application of such a technique requires the development of a certain level of qualification and a sufficient amount of knowledge. Only a specialist will be able to carefully examine each indicator and accurately calculate the current cost of a project. Discounting cash flows has the property of temporality, since the new value quickly loses its relevance, especially at the micro level, when any movement of assets and funds influences.
To obtain more accurate and reliable information, the specialist performs calculations in two ways. The first method involves taking into account the time factor, and the second, accordingly, does not take it into account. Discounting cash flows allows an investor to make a decision on investing taking into account risk factors and the effects of inflation. You can compare the profit received in different periods of time. To do this, you should get the difference between the proceeds of the funds and all costs discounted using the same interest rate. Thus, net discounted cash flows are obtained.
The accuracy and correctness of the results of the analysis depends not only on the data provided, but also on the correct selection of the discount rate. To determine it, one of three popular methods is used: calculating the weighted average cost of funds, analysis of assets calculated for long-term use, and cumulative construction. The latter method is most respected by specialists and is used most often. This is because this method most accurately takes into account the degree of riskiness of the operation.
Discounting cash flows is considered the most reliable method for determining the rationality of investment. Its advantages are not in any doubt. But there is a drawback, which is the complexity of the process. To obtain the most accurate and true result will require significant investment of time and enormous patience on the part of the specialist.
In addition, discounting cash flows takes into account not only the degree of risk, but also inflation expectations. Accounting for changes in inflation can be done by one of two basic methods. According to the first method, the inflation component is taken into account when calculating the discount rate, and with the second option, each flow is deflated during accounting. That is, the second method involves the inclusion of inflationary changes immediately.
The method of discounting flows is based on the preparation of a specific model of the financial activities of the company. As a rule, such a model is developed on the basis of the analysis of the profit and loss statement and documents reflecting the movement of cash and funds in the accounts of the enterprise. To obtain free cash flow, it is necessary to reduce the capital flow from operating activities by the amount of investment. The received amount of funds is considered the income of the organization, part of which is used for settlements with creditors and borrowers, and part is distributed among all shareholders in the form of dividend payments.
Based on the results of the analysis carried out using discounting, the specialist concludes that it is possible to improve the production process, about the feasibility of involving funds in other projects in order to increase profits in the future.