Discounting Uncertain Cash Flows

Overview

One of the principle problems in discounted cash flow analysis is that the cash flows are uncertain. At best, one can create a forecast of cash flows using the standard techniques of time series analysis.

Once a forecast has been created, an appropriate discount rate needs to be chosen.

Cash Flow Forecast

When creating a discounted cash flow analysis, the first step is calculating the cash flows to be discounted. Most analysis are of uncertain cash flows that will occur in the future. Given this problem, it is not clear that standard present value analysis applies.

From an intuitive standpoint, one could create a forecast of cash flows. Typically this would mean that one is calculating what one believes to the be probability weighted average of the possible future cash flows. This would give the analyst a single cash flow stream with which to discount.

ONe simple method to create a forecast would be take todays cash flow and then apply an average growth rate to todays value to obtain future values.

One way to measure the average growth rate would be to run a standard regression against the logarithm of past cash flow values, the slope then being an estimate of the growth rate.

Discount Rate

The discount rate to apply to these uncertain (risky) cash flows cannot be the same rate that is applied to cash flows that are known with certainty. This follows from the assumption that most investors are risk averse, that is, the prefer to buy an asset with less risk, all things being equal. This must mean that there is an additional discount added to uncertain cash flows. (see discounting risky cash flows)