Calculating a discounted cashflow

The project cashflow discussed so far follows a pattern typical of E P projects a number of years of expenditure (giving rise to cash deficits) at the beginning of the project, followed by a series of cash surpluses. The annual cashflows need to be evaluated to incorporate the timing of the cash flows, to account for the effect of the time value of monef. The technique which allows the values of sums of money spent at different times to be consistently compared is called discounting. 

Suppose you have to meet an obligation to pay a bill of 10,000 in 5 years time. If you could be guaranteed a compound interest rate in your bank of 7% per annum (after tax) over each of the next 5 years, then the sum which you would have to invest today to be able to meet the obligation in 5 years time would be  

What we have calculated is the present value (at a particular reference date) of a future sum of money, using a specified discount rate. In any discounting calculation, it is important to quote the reference date and the discount rate. 

If you were offered 7,130 today, or 10,000 in exactly 5 years time, you should be indifferent to the options, unless you could find an alternative investment opportunity which yielded a guaranteed interest rate better than the bank (in which case you should accept the money today and take the alternative investment opportunity). 

The closest analogy to a project investment is to consider how much you are required to pay today for the promise of 10,000 in 5 years time. Assuming the only options are the bank or the offer, then the maximum you should be prepared to pay today is 7,130. If you are requested to pay more, then you would do better by putting the 7,130 in the bank. 

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