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what does discounting the cashflow means ?Does that mean that we are eliminating the effect of interest ,inflation and risk ,to convert cashflows to their P.V ?
Discounting is removing the interest. It does not eliminate the effect of inflation and risk directly (although these can be taken into account when deciding on the discount rate).
Discounting gives you the value of the amount in the future if you were to receive it today. It reverses the effect of inflation. To include risk in the equation you’d be looking at the expected value of an amount to be received in the future.
Interest rates relate to inflation in that:
the inflation rate + the real interest rate = nominal interest rate
Not quite.
Discounting does not reverse the effect of inflation – it simply ‘removes’ the interest.
In theory, interest rates and inflation move up and down together, and therefore if we discount the current price flows at the real interest rate then we can ignore inflation.
However, usually in the exam there are different inflation rates applying to different flows and therefore we discount the actual cash flows at the actual (nominal) interest rate.To deal with risk, we can discount at a ‘risk adjusted discount rate’. This means that the more risky the project is, the higher the interest rate we use.
Capital asset pricing model is used to calculate the discount rate.True, but it is the most practical model available at the moment.
Obviously, for the calculations in F9 we assume CAPM does work. It is in the written sections that you can be expected to discuss the reservations.
Vey well explained John..you just explained simply what i have been trying to understand for more than 2 yrs!!!
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