Valuing Cash Flows in Different Periods

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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Corporate Finance