Discounting Formula

Formula to Calculate Discounted Values

Discounting refers to adjusting the future cash flows to calculate the present value of cash flows and adjusted for compounding where the discounting formula is one plus discount rate divided by a number of year’s whole raise to the power number of compounding periods of the discounting rate per year into a number of years.

Discounting Formula primarily converts the future cash flows to present value by using the discounting factor. Discounting is a vital concept as it helps in comparing various projects and alternatives that conflict while making decisions since the timeline for those projects could be different. Discounting them back to the present will ease comparison. Further, discounting is also used in making investment decisions. Discounting is nothing but a compounding concept in a reverse way, and it will decrease as the time will increases.

The equation for Discounting is:

Dn = 1 / (1+r)n
Discounting-Formula

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For eg:
Source: Discounting Formula (wallstreetmojo.com)

Where,

  • Dn is the Discounting factor
  • r is the Discounting rate
  • n is the number of periods in discounting

Steps to Calculate Discounted Values

To calculate discounted values, we need to follow the below steps.

  1. Calculate the cash flows for the asset and timeline that is in which year they will follow.

  2. Calculate the discount factorsDiscount FactorsDiscount Factor is a weighing factor most often used to find the present value of future cash flows, i.e., to calculate the Net Present Value (NPV). It is determined by, 1 / {1 * (1 + Discount Rate) Period Number}read moreDiscount Factor is a weighing factor most often used to find the present value of future cash flows, i.e., to calculate the Net Present Value (NPV). It is determined by, 1 / {1 * (1 + Discount Rate) Period Number}read moreDiscount Factor is a weighing factor most often used to find the present value of future cash flows, i.e., to calculate the Net Present Value (NPV). It is determined by, 1 / {1 * (1 + Discount Rate) Period Number}read more for the respective years using the formula.

  3. Multiply the result obtained in step 1 by step 2. This will give us the present valuePresent ValuePresent Value (PV) is the today's value of money you expect to get from future income. It is computed as the sum of future investment returns discounted at a certain rate of return expectation.read morePresent Value (PV) is the today's value of money you expect to get from future income. It is computed as the sum of future investment returns discounted at a certain rate of return expectation.read morePresent Value (PV) is the today's value of money you expect to get from future income. It is computed as the sum of future investment returns discounted at a certain rate of return expectation.read more of the cash flow.

Examples

You can download this Discounting Formula Excel Template here – Discounting Formula Excel Template

Example #1

Veronica is expecting the following cash flows in the future from her recurring deposit. Her son, however, needs funds today, and she is considering taking out those cash flows today, and she wants to know what the present value for those is if she withdraws today.

Discounting Formula Example 1.0.1

You are required to calculate the present values of those cash flows at 7% and calculate the total of those discounting cash flows.

Solution:

We are given the cash flows as well as the discount factor. All we need to do is discount them back to present value by using the above discounting equation.

First, we need to calculate discount factors which would be

cash flow 1.1

Discount Factor for Year 1 = 1/(1+(7%)^1

The discount factor for Year 1 will be –

Discounting Formula Example 1.2

Discount Factor for Year 1 = 0.93458

Calculation of Discounted Cash Flow will be –

cash flow 1.3

Lastly, we need to multiply each year’s cash flow with the discount factor Calculating above.

For example, for year one, it would 5,000 * 0.93458, which will be 4,672.90, and similarly, we can calculate for the rest of the years.

Discounted Cash Flow for Year 1 = 4672.90

Below is a summary of the calculations of discount factors and discounted cash flow that Veronica will receive in today’s term.

Discounting Formula Example 1.4

Total = 12770.57

Example #2

Mr. V is employed in an MNC company for around 20 years, and the company has been investing in a retirement fund, and Mr. V can withdraw the same when he reaches the retirement age, which is 60. The company has deposited till now $50,000 in his account as full and final. The company, however, allows only 60% premature withdrawal, which shall also be taxable and such withdrawal is allowed only in specific cases.

Mr. V, who is currently aging 43 years old, came up with an urgent requirement of funds for medical expenses, and this condition is met for premature withdrawal. And he also has FD, which is maturing at a similar period and is amounting to $60,000. He is thinking of breaking his FD as another option. However, Bank allows only 75% premature withdrawal, and this would also be liable for the tax.

The tax rate for Mr. V is 30% flat for FD and 10% flat for the retirement fund. You are required to advise Mr. V as to what should be done? Use 5% as a discount rate.

Solution:

First, we will calculate cash flows, which would be the related percentage as per given in the problem, and will deduct the tax amount, and that final amounted will be discounted for years remaining, which is 17 years (60 – 43).

Use the following data for the calculation of the discount factors.

cash flow 2.0

Calculation of the Discount Factor for retirement fund can be done as follows:

Discounting Formula Example 2.0.2

Discount Factor for Retirement Fund= 1/(1+0.05)^17

The discount Factor will be-

cash flow 2.2

Discount Factor for Retirement Fund = 0.43630

Calculation of Discounted Amount for Retirement fund will be –

Discounting Formula Example 2.3

Discounted Amount for Retirement Fund = 11780.01

Calculation of the Discount Factor for FD can be done as follows:

cash flow 2.4

Discount Factor for FD = 1/(1+0.05)^17

The discount Factor for FD will be –

Discounting Formula Example 2.5

Discount Factor for FD = 0.43630

Calculation of Discounted Amount for FD Will be –

cash flow 2.6

Discounted Amount for FD = 13743.35

Hence, he can opt to withdraw from the FD fund as it maxes the present value amount in hand.

Example #3

ABC Incorporation wants to invest in on-the-run treasury bonds. However, they are skeptical about investing in the same as they believe they first want to do valuation of the treasury bond since the investment amount they are looking for is approx—$ 50 million.

The research department has provided them with security details of the bond.

  • Life of the bond=3 years
  • Coupon frequency= semi-annually
  • 1st Settlement date=1st Jan 2019
  • Coupon Rate=8.00%
  • Par Value=$1,000

The Spot rate in the market is 8.25%, and Bond is currently trading at $879.78.

You are required to advise whether ABC Inc should invest in this bond or not?

Solution:

The question here is asking us to calculate the intrinsic value of the Bond, which can be done by discounting the cash flows of the bond that are to be received.

First, we will calculate the cash flows that are expected in the investment: Also, note that the bond pays semi-annually, and hence the coupon would be paid will behalf, which would 8/2 % on par value $1,000, which is $40.

Discounting Formula Example 0.3

Now, as a second step, we will calculate the discount factors in excel for each of the periods using 8.25%. Since we are competing for a half year period and the life of the bond is 3 years; therefore, 3 * 2 which is 6 and hence we need 6 discount factors.

Calculation of discount factor in excel for Year 1 can be done as follows.

cash flow 3.1

The discount factor in excel for Year 1 will be –

Discounting Formula Example 3.2

Calculation of Discounted Cash Flow will be –

cash flow 3.3

Lastly, we need to multiply each period cash flow with the discount factor Calculating above.

For example, for period 1, it would 40 * 0.96038, which will be 38.42, and similarly, we can calculate for the rest of the periods.

Below is the summary of our calculations and total discounted cash flow.

Discounting Formula Example 3.4

Since the current market price of the bond, $879.78 is less than the intrinsic value of the bond Calculated above, which states its undervalued, the company can make an investment in the bond.

Recommended Articles

This article has been a guide to Discounting Formula. Here we discuss the formula of discounting to calculate the present value of future cash flows along with excel examples and downloadable templates. You can learn more about financial analysis from the following articles –

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