Question

Explain why discounting would be necessary on analysis of a project that is expected to last 10 years. The project will involve uneven cash flows for 10 years. As this is not a math problem the amount per year is not an issue but the total is expected to be $15,000,000 over the ten-year period.

When answering, please consider:

• the risk involved for the company/shareholders,
• the product being produced by the investment (in style/fashion, i.e. plain or boutique, high tech vs. low tech, international or domestic market, etc.),
• governmental considerations - regulations, international, tax

The answer should be positive in that something could go wrong but you, the financial analyst, have considered the potential problem and the ramifications if the event did happen.

Answer 1

Discounting is the process of identifying the present value of cash flows that are due to be received in future. Discounting of Cash flow is necessary as Time has Value. Time is the most important element in analysing the viability of the project.

If you have money today, that is of much more value than compared to the money you are being promised to give 10 years later.

So the interest rate taken to discount the cash flows depend on the number of factors:

1) The market rate of interest

2) The risk appetite of company and whether the project is funded by debt security or equity or other instruments.

3) The inflation rate

While keeping all the factors of risk , taxation , goverment policy discounting is an utmost thing to do as value of money decreases with increase in time.