Discounting

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What is discount?

Discounting is the process of determining the present value of a payment or a payment stream that is to be received in the future. Given the time value of money, a dollar is worth more today than it would be tomorrow. Discounting is the main factor used to price a future cash flow.

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Discount with discount rate

How the discount works

For example, coupon payments found in a regular bond are discounted by a certain interest rate and added with the discounted face value to determine the present value of the bond.

From a business perspective, an asset has value only if it can generate cash flow in the future. Stocks pay dividends. The bonds bear interest and the projects provide investors with additional future cash flows. The value of these future cash flows in current terms is calculated by applying a discount factor to future cash flows.

Key points to remember

  • Discounting is the process of determining the present value of a future payment or payment stream.
  • A dollar is always worth more today than it would be tomorrow, according to the concept of the time value of money.
  • A higher haircut indicates a higher level of risk associated with an investment and its future cash flows.

Time value of money and discount

When a car is on sale for 10% discount, this represents a discount on the price of the car. The same discounting concept is used to value and evaluate financial assets. For example, the present or present value is the value of the bond today. Future value is the value of the bond at some point in the future. The difference in value between the future and the present is created by updating the future to the present using a discount factor, which is a function of time and interest rates.

For example, a bond can have a face value of $ 1,000 and be valued at a 20% discount, or $ 800. In other words, the investor can buy the bond today for a discount and receive the full face value of the bond at maturity. The difference is the return of the investor.

A higher discount translates into a higher return, which is a function of risk.

Update and risk

In general, the higher the discount, the higher the level of risk associated with an investment and its future cash flows. Discounting is the main factor used to price a future cash flow. For example, the company’s profit cash flows are discounted at cost of capital in the discounted cash flow model. In other words, future cash flows are discounted at a rate equal to the cost of obtaining the funds necessary to finance the cash flows. A higher interest rate paid on the debt also equates to a higher level of risk, which generates a higher discount and lowers the present value of the bond. Indeed, junk bonds are sold at a heavy discount. Likewise, a higher level of risk associated with a particular action, represented as beta in the fixed asset pricing model, means a higher discount, which lowers the current value of the action.

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