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Encyclopedia > Discount

In finance, discounting is the process of finding the current value of an amount of cash at some future date, and along with compounding cash from the basis of time value of money calculations. The discounted value of a cash flow is determined by reducing its value by the appropriate discount rate for each unit of time between the time when the cashflow is to be valued to the time of the cash flow. Most often the discount rate is expressed as an annual rate. Finance studies and addresses the ways in which individuals, businesses and organizations raise, allocate and use monetary resources over time, taking into account the risks entailed in their projects. ... The time value of money (TVM) or the discounted present value is one of the basic concepts of finance, developed by Leonardo Fibonacci in 1202. ... In finance, cash flow refers to the amounts of cash being received and spent by a business during a defined period of time, sometimes tied to a specific project. ... The term discount rate is used in several different contexts: mathematical discount rate, monetary policy, and project valuation. ...


To calculate the net present value of a single cash flow, it is divided by one plus the interest rate for each period of time that will pass. This is expressed mathematically as raising the divisor to the power of the number of units of time. Net present value is a valuation method based on discounted cash flows. ...

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Example

As an example, suppose an individual wants to find the net present value of $100 that will be received in five years time. There is a question of how much is it worth presently, and what amount of money, if one lets it grow at the discount rate, would equal $100 in five years. Net present value is a valuation method based on discounted cash flows. ...


Let one assume a 12% per year discount rate.


NPV = 100 dollars divided by 1 plus 12% (0.12) divided by 1 plus 12% (0.12), etc.

Since 1.125 is about 1.762, the net present value is about $56.74. Net present value is a valuation method based on discounted cash flows. ...


Discount rate

The discount rate which is used in financial calculations is usually chosen to be equal to the cost of capital. Some adjustment may be made to the discount rate to take account of risks associated with uncertain cashflows, with other developments. The cost of capital for a firm is a weighted sum of the cost of equity and the cost of debt (see the financing decision). ...


When looking at discount rates typically applied to different types of companies it shows very large differences:

  • Startups seeking money: 50 – 100 %
  • Early Startups: 40 – 60 %
  • Late Startups: 30 – 50%
  • Mature Companies: 10 – 25%

Reason for high discount rates for startups:

  • Reduced marketability of ownerships because stocks are not traded publicly
  • Limited number of investors willing to invest
  • Startups face high risks
  • Over optimistic forecasts by enthusiastic founders.

One method that looks into a correct discount rate is the capital asset pricing model. This model takes in account three variables that make up the discount rate: The capital asset pricing model (CAPM) is used in finance to determine a theoretically appropriate required rate of return (and thus the price if expected cash flows can be estimated) of an asset given that assets non-diversifiable risk. ...


1. Risk Free Rate: The percentage of return generated by investing in risk free securities such as government bonds.


2. Beta: The measurement of how a company’s stock price reacts to a change in the market. A beta higher than 1 means that a change in share price is more exaggerated then rest of shares in the same market. A beta less than 1 means that the share is stable and not very responsive to changes in the market. Less than 0 means that a share is moving in the opposite of the market change.


3. Equity Market Risk Premium: The return on investment that investors require above the risk free rate.


Discount rate= risk free rate + beta*(equity market risk premium)


Discount factor

The discount factor', P(T), is the number by which a future cash flow to be received at time T must be multiplied in order to obtain the current present value. Thus for a fixed annually compounded discount rate r we have

P(T) = frac{1}{(1+r)^T}

For fixed continuously compounded discount rate r we have

P(T) = e rT

Other discounts

For discounts in marketing, see discounts and allowances, sales promotion, and pricing. It has been suggested that Product marketing be merged into this article or section. ... Discounts and allowances are modifications to the basic price. ... In marketing, sales promotion is one of the four aspects of promotion. ... To meet Wikipedias quality standards, this article or section may require cleanup. ...


See also

See also Coupon (bond) In marketing a coupon is a ticket or document that can be exchanged for a financial discount or rebate when purchasing a product. ...

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  Results from FactBites:
 
Discount - Wikipedia, the free encyclopedia (534 words)
In finance, discounting is the process of finding the current value of an amount of cash at some future date, and along with compounding cash from the basis of time value of money calculations.
The discounted value of a cash flow is determined by reducing its value by the appropriate discount rate for each unit of time between the time when the cashflow is to be valued to the time of the cash flow.
The discount rate which is used in financial calculations is usually chosen to be equal to the cost of capital.
  More results at FactBites »

 
 

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