Discounting

Reviewed by Sweta | Updated on Aug 26, 2020

Introduction

Discounting is the process of calculating the present value of future cash flow receipts. Discounting takes into account the time value of money. A sum of money is worth more today than it is worth tomorrow.

Understanding Discounting

Discounting helps in pricing issues based on the future financial prospects of a company. In the case of bonds, the present market price is determined by discounting the future interest payments.

The discounting factor is applied to determine today's price of future cash flow receipts.

Factors to Consider

  1. An asset or investment has value only if it can produce future cash flows. Equity investments or stocks yield dividends or capital appreciation. Bondholders receive interest annually. Investments in projects or business expansion yield future cash flows.

  2. The process of discounting involves the use of a discount factor based on time and interest rate.

  3. Risky investments carry a higher discounting rate. In other words, a high discount rate indicates a higher level of risk in the investment. In a capital asset pricing model, the high level of risk is represented by a beta translating to a higher discount and a low present value of the security.

  4. The discount rate would be the rate or the cost of procuring the funds to finance the future cash flows.

  5. Discounting is the primary factor used to price future cash flows of an enterprise.

  6. In the case of a company, future earnings are discounted at the cost of capital.

  7. The difference between the future value and present value is determined by discounting the future value to the present. For example, a bond of face value Rs 10,000 issued at a 10% discount today at Rs 9,000. An investor who purchases the bond today will redeem the same face value at the end of the tenure.