What is the purpose of discounting free cash flow to present value?

• A. To reflect the time value of money and risk, converting future cash flows to present value
• B. To maximize future cash flows
• C. To estimate depreciation
• D. To set tax rates

Answer: (A)

Money today is worth more than the same amount in the future because you could invest it and earn a return, while also bearing risk. Discounting free cash flow to present value converts each future cash flow into its equivalent value today, using a discount rate that reflects both the time value of money and risk. By summing these present values, you get the total present value of all expected future cash flows. This lets you compare that value to the initial investment to judge whether the project or business is worthwhile. For example, $110 received next year has a present value of about $100 if the discount rate is 10%, illustrating how future money is translated into today’s terms. The approach is central to discounted cash flow valuation and investment decisions because it directly accounts for when money is received and the risk involved.