Discounting 6 / 8

Calculating a present value (from future values)

Ok - so we have seen how to work out future values from present values.

(Using inflation as the example)

However, when looking at whether we should invest in something we will be looking at future cashflows coming in.

We want to know what are these future cashflows worth now, in today’s money ideally.

To do this we need to work the other way around ie. Take the future value (FV) and work out the present value (PV). We do this by:

Discounting

  • Discount Factors

    It is the discounted cash flows that we want to end up with in an NPV question. So we put the future cash flows in, and then discount them using a discount factor. These are given in discount factor tables in the exam but can be calculated as follows:

    If you want to calculate a 10% discount factor for year 1 - It is 1 divided by 1.10 = 0.909

    If you want to calculate a 10% discount factor for year 2 - It is 1 divided by 1.10 divided by 1.10 = 0.826

    If you want to calculate a 10% discount factor for year 3 - It is 1 divided by 1.10 divided by 1.10 divided by 1.10 = 0.751

    If you want to calculate a 6% discount factor for year 1 - It is 1 divided by 1.06 = 0.943

    If you want to calculate a 12% discount factor for year 1 - It is 1 divided by 1.12 = 0.893

Illustration

You are to receive £100 in one year’s time and the interest rate/discount rate is 10%. What is the PV of that money?

  • 100 x 1 /1.10
    = 90.9

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