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Discounted cash flow and net present value are two concepts that are connected in the world of finance because the discounted cash flow essentially determines the net present value. It does this by taking into account the fact that money loses value over time, meaning that a sum of money in the future will not be worth as much as the same sum of money in the present. By discounting promised future cash flow, the net present value of that amount can be determined. This is a beneficial calculation to make when a financial decision needs to be made about an investment or project that promises to bring in a certain amount of money over time.
Making business decisions can be difficult even when one possible choice is almost certain to bring in a future amount of money. That is because inflation in economies is practically guaranteed over time, meaning that a certain amount of money in one's hand at the present time is more valuable than that same amount in hand years down the road. The time value of money is a crucial concept to understand, and it's at the heart of the relationship between discounted cash flow and net present value.
To understand how discounted cash flow and net present value are connected, it is helpful to think of an investment that promises interest payments. If the investor reinvests the interest, the interest is compounded and adds more to the amount of each payment. An inverse relationship to that takes place concerning some amount of money in the future and its actual worth in the present.
If the future value is known, a discount rate can be used to reduce this amount back down to its present value. This is done in practically the same way as the compounded interest calculation. Just as an investment with compounded interest becomes more valuable the longer it is held, a sum of money becomes less valuable if it is realized many years in the future. The amount left in the present after the discount has occurred is the net present value.
It is important when considering discounted cash flow and net present value that a proper discount rate is chosen. Those making the business or investment decision have to determine this rate based on a number of factors. Chief among them is the amount of risk involved that the investment may not reach the predicted future cash flows. If there is a high risk of this occurring, the discount rate should be proportionately high to account for this.
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