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Quantitative Finance by Matt Davison

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Chapter 4

Valuing Investment Opportunities

The Discounted Cash Flow Method

4.1 CHAPTER SUMMARY

As mentioned in the introduction, finance involves return, risk, and time. For many years, projects carried out over multiple years with uncertain cash flows were evaluated using the so-called discounted cash flow method, also known as the present value of the expected value method.

This method is conceptually very straightforward. Cash flows are assumed to occur at finitely many discretely spaced time periods. The size of the cash flow Dk at each period is a random variable with known probabilities Pk(Dk). The expected value of these random variables E(Dk), is computed at each time period. Cash flows at different times are compared by using a discount ...

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