Undiscounted Future Cash Flows
The concept of “Undiscounted Future Cash Flows” refers to the projections of cash flows that an investment or business is expected to generate in the future, without adjusting for the time value of money. In financial analysis, cash flows are usually “discounted” to account for the time value of money, meaning that future cash flows are worth less than immediate cash flows because of the opportunity cost of not having that money available for investment elsewhere.
However, in some contexts, you may want to look at the raw, or “undiscounted,” future cash flows. These are the nominal amounts of money that are expected to be received or paid at various future points in time, without any adjustment for the effect of inflation, risk, or the opportunity cost of capital.
Here are some scenarios where you might consider using undiscounted future cash flows:
- Initial Screening: As a preliminary step, you might evaluate an investment project using undiscounted cash flows to quickly judge its feasibility or attractiveness before diving into more detailed analysis.
- Risk-Free or Short-Term Analysis: In cases where risk is considered negligible or the time frame is very short, you might use undiscounted cash flows for simplicity.
- Regulatory or Contractual Requirements: Sometimes legal or regulatory requirements mandate the use of undiscounted cash flows for specific reporting purposes.
- Sensitivity Analysis: You might use undiscounted cash flows as part of a sensitivity analysis to understand how sensitive an investment’s attractiveness is to the discount rate used.
- Comparing to Current Cost: For projects with a relatively short time span, the undiscounted cash flows can be directly compared to the current cost of investment to get a rudimentary idea of profitability.
Although straightforward, it is essential to remember that using undiscounted future cash flows ignores the important economic principle of the time value of money, potentially leading to inaccurate or suboptimal investment decisions. Therefore, in most cases, it’s better to use discounted cash flow (DCF) techniques for a more accurate assessment of an investment’s worth.
Example of Undiscounted Future Cash Flows
Let’s consider a simple example involving a small investment in a vending machine business.
Scenario:
- You are considering purchasing a vending machine that costs $5,000.
- You estimate that the vending machine will generate the following cash inflows over the next 5 years:
- Year 1: $1,200
- Year 2: $1,400
- Year 3: $1,600
- Year 4: $1,800
- Year 5: $2,000
Using Undiscounted Future Cash Flows:
- Calculate Total Undiscounted Future Cash Flows: Add up all the future cash inflows.$1,200 + $1,400 + $1,600 + $1,800 + $2,000 = $8,000
- Compare to Initial Investment: The total undiscounted future cash inflows are $8,000, and the initial investment is $5,000.
- Initial Evaluation: Since the total undiscounted cash inflows ($8,000) are greater than the initial investment ($5,000), the investment looks attractive on the surface.
Limitations:
- Time Value of Money: This approach does not account for the time value of money. A dollar received in the future is not worth the same as a dollar today.
- Risk and Opportunity Cost: This approach does not account for the risk or the opportunity cost of using the $5,000 for some other investment.
More Comprehensive Analysis with Discounted Cash Flows:
To get a more accurate picture, you would usually discount these future cash flows back to their present value using a discount rate that accounts for the time value of money, risks, and opportunity costs. But the concept of undiscounted future cash flows provides a simple initial screening tool or a way to perform sensitivity analysis.
