Investment risk
Investment risk

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Investment risk

4.2 Discounted cash flow

Any investment gives rise to a stream of future expected cash flows. DCF converts all of these to an equivalent amount of present-day money (or present value) by discounting each future cash flow for the appropriate number of periods (for example, years) by the periodic discount rate. The periodic discount rate is the investor's required rate of return including the time preference rate, a premium for risk and an adjustment for inflation.

Having established the present values of each of our possible alternative investments, we now need to compare each present value with the cost of acquiring that investment today. This cost can be expressed as a negative cash flow and included in the DCF calculation at its face value (it is already expressed in present-day money terms, so it does not need to be discounted) by subtracting it from the present value of all the future expected returns. The difference between the positive present value of all the future returns and the negative present value of the initial investment gives us the net present value (NPV) of the overall investment.


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