Calculating the Present Value of An Asset's Future Cash Flows

Abstract

This paper describes both the theory and a computer program designed to calculate the present value of an asset's uncertain future cash flows. In this model expected flows may vary in each of t future periods. Flows are adjusted to a certainty equivalent by a correction factor derived from a covariance matrix of the flows and market returns. The flows are discounted by a full specification of the term structure of the risk-free interest rate. The specific model illustrated in the paper is that of expected cash flows from a mortgage portfolio. The computer program calculates the expected cash flow, the uncertainty correction, and the term structure of interest rates. Algorithms to solve for each of these factors are included. Alternatively, options are included to input the factors from exogenous forecasts or projections. In addition to calculating the present values under each specification for the factors, the program compares the present values derived from each particular specification.