Accounting and financial analysis are concerned with understanding the past and present, but finance professionals look to the future to answer the most crucial questions in terms of value. In essence, the source of today’s value lies in future performance, manifested through cash flows. This approach poses a challenge for finance because not all cash flows are created equal. Would your reaction be the same for a dollar collected today compared to a dollar collected ten years from now? Certainly not. Therefore, the field of finance endeavors to calculate the present value of an asset when contemplating its future cash flows.

The Challenge of Future Cash Flows

Summing up all future cash flows is more challenging than it seems, stemming from one of the fundamental principles of finance, the “time value of money.” This principle is straightforward: a dollar today is more valuable than a dollar a year from now.

The Time Value of Money

If you have a dollar today, you can invest it to generate returns, resulting in more than a dollar a year later. Consequently, the dollar you will earn a year from now should be less valuable than the dollar in your hand today. But how much less valuable can it be?

Opportunity Cost and Discount Rate

This difference depends on the opportunity cost of the money. What potential opportunity are you foregoing by not using this money immediately? After calculating the cost of waiting, you “penalize” future cash flows with this opportunity cost, and this penalizing mechanism is termed the “discount rate.” While discounting cash flows may seem peculiar, it’s essentially acknowledging that, during discounting, you are penalizing those who delay your money collection because waiting is undesirable. If you didn’t have to wait and could collect the money immediately, you could have utilized it for returns.