The most basic way of determining the present value of a future cash flow considers only 3 things:
- How much cash are we talking about?
- What is the interest rate that you could invest the cash in if you had it today instead of in the future?
- How long is the future? 1 year? 2 years?
Why would you be receiving that future cash flow anyway? Sometimes it’s cash that came from you. Sometimes it’s cash as payment for services you rendered. Consider the following three scenarios:
- You put in $10,000 in a term deposit.
- You lend $10,000 by buying a corporate bond.
- You provide a service to a company which now owes you $10,000
In each case, the other party has an obligation to pay you back your money. Is the chance that you will get paid the same? It’s almost certain you will get your money back from the term deposit. Even if the bank collapses, the $10,000 is most certainly covered by insurance.
The corporate bond is at risk if the company that issued the bond goes bankrupt. How likely this is depends on who the company is. A bond issued by an IBM is less risky than one issued by a smaller startup.
The company who owes you $10,000 may decide not to pay you at all.
Since the risk of not being paid in these scenarios is not different, there are two key things to note:
- The value of the future cash flow should not be the same.
- You would normally want to be compensated for taking more risk.
The most basic means of computing the future cash flow, as outlined above, is not adequate for computing future cash flows that have a certain amount of risk in them. The formula needs to incorporate the risk factor.
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