What Is Discounting?

Discounting is the process of bringing to the present value the future Net Cash Flows that will occur during the lifetime of the project. Specifically, reducing the value of future Net Cash Flows (or net profits) to give them their current value in today’s terms. 

In this way, different investment projects can be compared with each other by considering today’s value of their future cash returns.

Discounting is the opposite to compounding.

Time value of money

Discounting takes ‘time value of money’ into consideration. Time value of money means that USD1 promised at some time in the future.

Any cash (money) received in the future is not as valuable as cash received today. Money received today can be spent, saved or invested right away without waiting. The trade-off between money now and money later depends on, among other things, the rate you can earn by investing.

Money received today can be invested, or simply saved in a bank to earn the compound interest, and be worth more than the same money received in the future. Money received today is certain while future money is not guaranteed. Whereas money received in the future will have lost some of its value as inflation makes future money worth less than money received today.

The present value of future money

USD100 today at 5% interest annually. So, if inflation rate in a country is 5%, then USD100 today. This value of USD105 received in one year’s time.

USD1,000 today at 10% interest rate annually. So, if interest rate in a country is 10%, then USD1,000 today. This value of USD1,100 received in one year’s time.

USD100 today at 5% interest rate annually.

How to do discounting?

In order to do discounting properly, you shall use the discount factors to obtain present values of future Net Cash Flows. You need to multiply the Net Cash Flow by the appropriate discount factor from the discount table below:

Present Value of USD1,000 is expected in three years’ time and the current rate of interest is 6%. The discount factor to be used is 0.8396. This means that USD0.8396 today. USD839.6 So, USD839.6.  What does discounting depend on? So, exactly how much less is future cash worth compared to the same money today?  A discount factor is used to convert the future Net Cash Flow to its present value as of today. Given that receiving money today is worth more than it is in the future, that discount factor can be represented as inflation or interest rates.  In addition to the discount factor – the rate of inflation / the rate of interest – the present value of a future sum of money also depends on time, or the length of investment.  Inflation rate / Interest rate. The lower the rate of inflation / the rate of interest, the more value future cash has in today’s money. But, the higher the rate of inflation / the rate of interest, the less value future cash has in today’s money. Time. The shorter into the future cash is received, the more value it has today. But, the longer into the future cash is received, the less value it has today. In short, these two variables are used in discounting – calculating the present value of future money by using discount factors. — To sum up, because of the concept of ‘time value of money’, any cash received in the future is not as valuable as cash received today. This is because of the following four reasons: IN HAND. Money received today is certain while future money is not guaranteed. SPENDING. Money received today can be spent today without waiting. INVESTING. Money received today can be invested and worth more than the same money received in the future. NO INFLATION. Inflation makes money received in the future worth less than money received today. Jerry Grzegorzek I am the Founder and Editor-in-Chief of the SuperBusinessManager.com website. I am the EU citizen with approximately 20 years of experience in secondary and higher business education in both public and private sectors. Currently living with my wife and our two adorable children in China where I teach Business Management and Economics at K-12 international schools. Professionally, I am an experienced Lecturer and Researcher in Business Management and Economics, as well as IB Examiner for DP Business Management at International Baccalaureate (IB). Privately, I enjoy reading and collecting books on business management, personal finance and investing. You can contact me at jerrygrzegorzek@hotmail.com « What Is Compounding?    |    Net Present Value (NPV) of An Investment » Comments are closed. Scroll to the top Exit mobile version