It is a well known fact that the value of money undergoes changes over a period of time and rarely remains constant. In fact, the longer the time period, the higher is the change in the value of money. As it is, the value of money generally depreciates over time. Factors like inflation are responsible for this degradation.
Now, this depreciation in the value of money plays a very important role as far as the cash flow is concerned. This can be explained by way of an example. So, let us suppose that you deposit $1000 in an investment avenue, which guarantees you a return of 3% P.A. and the value of money gets depreciated at the rate of 4% P.A. then that means that you are at a loss.
In order to make sure that the business organization is not at loss, the discounted cash flow system was invented. The discounted cash flow system refers to a method of evaluation of a project, a company, or an asset by using the concept of Time Value of Money. In this system, all the future cash inflows and outflows are estimated and discounted in order to arrive at their current values. Here, the discount rate is usually the applicable cost of capital and it might incorporate the judgments in regard to the uncertainties of future cash flows.
As it is, the discounted cash flow method has been in use in some form or the other ever since money began to be lent on interest. As a way of asset evaluation it has generally been countered to accounting book value that has been on the basis of the amount which is paid for the asset. With the gradual course of time, the discounted cash flow system gained popularity as an evaluation method in regard to various aspects of business including stocks. Today, the discounted cash flow method is widely in use in terms of investment finance, as well as real estate development, apart from corporate financial management.
The discounted cash flow is determined with the help of the future value method for calculation of time value of money apart from compounding returns.
Now, for future value, the following formula is used
FV= DPV * (1+ i)n
Therefore, the discounted present value can be calculated as follows:
DPV= FV/ (1+i)n = FV (1- d)n
Where, DPV refers to the discounted present value of the future cash flow, FV refers to the nominal value of the amount of cash flow on a future period, i refers to the interest rate, that refers to factors like cost of capital, d refers to the discount rate, i.e. the interest rate which is a deduction in the beginning of the year, unlike an addition at the end of the year as in normal case and n refers to the time period in terms of years before the future cash flow takes place.