What Is Discounting? — Super Business Manager

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 USD$1 in hand today is worth more than USD$1 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

USD$105 in one year’s time has the same value as USD$100 today at 5% interest annually. So, if inflation rate in a country is 5%, then USD$105 next year is worth the same as USD$100 today. This value of USD$100 is called ‘the present value’ of USD$105 received in one year’s time.

USD$1,100 in one year’s time has the same value as USD$1,000 today at 10% interest rate annually. So, if interest rate in a country is 10%, then USD$1,100 next year is worth the same as USD$1,000 today. This value of USD$1,000 is called ‘the present value’ of USD$1,100 received in one year’s time.

USD$163 in ten years’ time has the same value as USD$100 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 USD$1
Year:	1%	2%	3%	4%	5%	6%	7%	8%	9%	10%	12%	14%
1	0.990	0.980	0.971	0.962	0.952	0.943	0.935	0.926	0.917	0.909	0.893	0.877
2	0.980	0.961	0.943	0.925	0.907	0.890	0.873	0.857	0.842	0.826	0.797	0.769
3	0.971	0.942	0.915	0.889	0.864	0.840	0.816	0.794	0.772	0.751	0.712	0.675
4	0.961	0.924	0.888	0.855	0.823	0.792	0.763	0.735	0.708	0.683	0.636	0.592
5	0.951	0.906	0.863	0.822	0.784	0.747	0.713	0.681	0.650	0.621	0.567	0.519
6	0.942	0.888	0.837	0.790	0.746	0.705	0.666	0.630	0.596	0.564	0.507	0.456
7	0.933	0.871	0.813	0.760	0.711	0.665	0.623	0.583	0.547	0.513	0.452	0.400
8	0.923	0.853	0.789	0.731	0.677	0.627	0.582	0.540	0.502	0.467	0.404	0.351
9	0.914	0.837	0.766	0.703	0.645	0.592	0.544	0.500	0.460	0.424	0.361	0.308
10	0.905	0.820	0.744	0.676	0.614	0.558	0.508	0.463	0.422	0.386	0.322	0.270
11	0.896	0.804	0.722	0.650	0.585	0.527	0.475	0.429	0.388	0.350	0.287	0.237
12	0.887	0.788	0.701	0.625	0.557	0.497	0.444	0.397	0.356	0.319	0.257	0.208
13	0.879	0.773	0.681	0.601	0.530	0.469	0.415	0.368	0.326	0.290	0.229	0.182
14	0.870	0.758	0.661	0.577	0.505	0.442	0.388	0.340	0.299	0.263	0.205	0.160
15	0.861	0.743	0.642	0.555	0.481	0.417	0.362	0.315	0.275	0.239	0.183	0.140
16	0.853	0.728	0.623	0.534	0.458	0.394	0.339	0.292	0.252	0.218	0.163	0.123
17	0.844	0.714	0.605	0.513	0.436	0.371	0.317	0.270	0.231	0.198	0.146	0.108
18	0.836	0.700	0.587	0.494	0.416	0.350	0.296	0.250	0.212	0.180	0.130	0.095
19	0.828	0.686	0.570	0.475	0.396	0.331	0.277	0.232	0.194	0.164	0.116	0.083
20	0.820	0.673	0.554	0.456	0.377	0.312	0.258	0.215	0.178	0.149	0.104	0.073

The very standard Discount Table.

Discounted Net Cash Flow is calculated by multiplying Net Cash Flow by a Discount Factor (%):

Discounted Net Cash Flow = Net Cash Flow x Discount Factor (%)

where:

Discounted Net Cash Flow = Present Value

Let’s say USD$1,000 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 USD$1 received in three years’ time is worth the same as USD$0.8396 today.

USD$1,000 x 0.8396 = USD$839.6

So, USD$1,000 is multiplied by this discount factor and the present value is USD$839.6.

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.