Discounting

From Wikipedia, the free encyclopedia

For discounting in the sense of downplaying or dismissing, see Minimisation (psy
chology). For the band of the same name, see Discount (band). See also: Discount
s and allowances
Discounting is a financial mechanism in which a debtor obtains the right to dela
y payments to a creditor, for a defined period of time, in exchange for a charge
or fee.[1] Essentially, the party that owes money in the present purchases the
right to delay the payment until some future date.[2] The discount, or charge, i
s the difference (expressed as a difference in the same units (absolute) or in p
ercentage terms (relative), or as a ratio) between the original amount owed in t
he present and the amount that has to be paid in the future to settle the debt.[
1]
The discount is usually associated with a discount rate, which is also called th
e discount yield.[1][1][2][3] The discount yield is the proportional share of th
e initial amount owed (initial liability) that must be paid to delay payment for
1 year.
discount yield = "charge" to delay payment for 1 year / debt liability
It is also the rate at which the amount owed must rise to delay payment for 1 ye
ar.
Since a person can earn a return on money invested over some period of time, mos
t economic and financial models assume the discount yield is the same as the rat
e of return the person could receive by investing this money elsewhere (in asset
s of similar risk) over the given period of time covered by the delay in payment
.[1][2] The concept is associated with the opportunity cost of not having use of
the money for the period of time covered by the delay in payment. The relations
hip between the discount yield and the rate of return on other financial assets
is usually discussed in such economic and financial theories involving the inter
-relation between various market prices, and the achievement of Pareto optimalit
y through the operations in the capitalistic price mechanism,[2] as well as in t
he discussion of the efficient (financial) market hypothesis.[1][2][4] The perso
n delaying the payment of the current liability is essentially compensating the
person to whom he/she owes money for the lost revenue that could be earned from
an investment during the time period covered by the delay in payment.[1] Accordi
ngly, it is the relevant "discount yield" that determines the "discount", and no
t the other way around.
As indicated, the rate of return is usually calculated in accordance to an annua
l return on investment. Since an investor earns a return on the original princip
al amount of the investment as well as on any prior period investment income, in
vestment earnings are "compounded" as time advances.[1][2] Therefore, considerin
g the fact that the "discount" must match the benefits obtained from a similar i
nvestment asset, the "discount yield" must be used within the same compounding m
echanism to negotiate an increase in the size of the "discount" whenever the tim
e period of the payment is delayed or extended.[2][4] The "discount rate" is the
rate at which the "discount" must grow as the delay in payment is extended.[5]
This fact is directly tied into the time value of money and its calculations.[1]
The "time value of money" indicates there is a difference between the "future va
lue" of a payment and the "present value" of the same payment. The rate of retur
n on investment should be the dominant factor in evaluating the market's assessm
ent of the difference between the future value and the present value of a paymen
t; and it is the market's assessment that counts the most.[4] Therefore, the "di
scount yield", which is predetermined by a related return on investment that is
found in the financial markets, is what is used within the time-value-of-money c
alculations to determine the "discount" required to delay payment of a financial

liability for a given period of time.

Contents [hide]
1
Basic calculation
2
Discount rate
3
Discount factor
4
Other discounts
5
See also
6
References
7
External links
Basic calculation[edit]
If we consider the value of the original payment presently due to be P, and the
debtor wants to delay the payment for t years, then an r Market Rate of Return o
n a similar Investment Assets means the future value of P is {\displaystyle P(1+
r)^{t}} ,[2][5] and the discount would be calculated as
{\displaystyle {\text{Discount}}=P(1+r)^{t}-P} [2]
where r is also the discount yield.
If F is a payment that will be made t years in the future, then the "Present Val
ue" of this Payment, also called the "Discounted Value" of the payment, is
{\displaystyle P={\frac {F}{(1+r)^{t}}}} [2]
To calculate the 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 math
ematically as raising the divisor to the power of the number of units of time.
Consider the task to find the present value PV of $100 that will be received in
five years. Or equivalently, to find which amount of money today will grow to $1
00 in five years when subject to a constant discount rate.
Assuming a 12% per year interest rate, it follows that
{\displaystyle {\rm {PV}}={\frac {\$100}{(1+0.12)^{5}}}=\$56.74.}
Discount rate[edit]
The discount rate which is used in financial calculations is usually chosen to b
e equal to the cost of capital. The cost of capital, in a financial market equil
ibrium, will be the same as the market rate of return on the financial asset mix
ture the firm uses to finance capital investment. Some adjustment may be made to
the discount rate to take account of risks associated with uncertain cash flows
, with other developments.
The discount rates typically applied to different types of companies show signif
icant differences:
Start-ups seeking money: 50100%
Early start-ups: 4060%
Late start-ups: 3050%
Mature companies: 1025%
The higher discount rate for start-ups reflects the various disadvantages they f
ace, compared to established companies:
Reduced marketability of ownerships because stocks are not traded publicly
Limited number of investors willing to invest
High risks associated with start-ups
Overly optimistic forecasts by enthusiastic founders
One method that looks into a correct discount rate is the capital asset pricing
model. This model takes into account three variables that make up the discount r
ate:

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 th
e market. A beta higher than 1 means that a change in share price is exaggerated
compared to the rest of shares in the same market. A beta less than 1 means tha
t the share is stable and not very responsive to changes in the market. Less tha
n 0 means that a share is moving in the opposite direction from the rest of the
shares in the same market.
3. Equity market risk premium: The return on investment that investors require a
bove the risk free rate.
Discount rate = (risk free rate) + beta * (equity market risk premium)
Discount factor[edit]
The discount factor, DF(T), is the factor by which a future cash flow must be mu
ltiplied in order to obtain the present value. For a zero-rate (also called spot
rate) r, taken from a yield curve, and a time to cash flow T (in years), the di
scount factor is:
{\displaystyle DF(T)={\frac {1}{(1+rT)}}}
In the case where the only discount rate you have is not a zero-rate (neither ta
ken from a zero-coupon bond nor converted from a swap rate to a zero-rate throug
h bootstrapping) but an annually-compounded rate (for example if your benchmark
is a US Treasury bond with annual coupons and you only have its yield to maturit
y, you would use an annually-compounded discount factor:
{\displaystyle DF(T)={\frac {1}{(1+r)^{T}}}}
However, when operating in a bank, where the amount the bank can lend (and there
fore get interest) is linked to the value of its assets (including accrued inter
est), traders usually use daily compounding to discount cash flows. Indeed, even
if the interest of the bonds it holds (for example) is paid semi-annually, the
value of its book of bond will increase daily, thanks to accrued interest being
accounted for, and therefore the bank will be able to re-invest these daily accr
ued interest (by lending additional money or buying more financial products). In
that case, the discount factor is then (if the usual money market day count con
vention for the currency is ACT/360, in case of currencies such as United States
dollar, euro, Japanese yen), with r the zero-rate and T the time to cash flow i
n years:
{\displaystyle DF(T)={\frac {1}{(1+{\frac {r}{360}})^{360T}}}}
or, in case the market convention for the currency being discounted is ACT/365 (
AUD, CAD, GBP):
{\displaystyle DF(T)={\frac {1}{(1+{\frac {r}{365}})^{365T}}}}
Sometimes, for manual calculation, the continuously-compounded hypothesis is a c
lose-enough approximation of the daily-compounding hypothesis, and makes calcula
tion easier (even though it does not have any real application as no financial i
nstrument is continuously compounded). In that case, the discount factor is:
{\displaystyle DF(T)=e^{-rT}\,}
Other discounts[edit]
For discounts in marketing, see discounts and allowances, sales promotion, and p
ricing. The article on discounted cash flow provides an example about discountin
g and risks in real estate investments.
See also[edit]
Coupon
Coupon (bond)
High-low pricing

Hyperbolic discounting
References[edit]
Notes
^ Jump up to: a b c d e f g h i See "Time Value", "Discount", "Discount Yield",
"Compound Interest", "Efficient Market", "Market Value" and "Opportunity Cost" i
n Downes, J. and Goodman, J. E. Dictionary of Finance and Investment Terms, Baro
n's Financial Guides, 2003.
^ Jump up to: a b c d e f g h i j See "Discount", "Compound Interest", "Efficien
t Markets Hypothesis", "Efficient Resource Allocation", "Pareto-Optimality", "Pr
ice", "Price Mechanism" and "Efficient Market" in Black, John, Oxford Dictionary
of Economics, Oxford University Press, 2002.
Jump up ^ Here, the discount rate is different from the discount rate the nation
's Central Bank charges financial institutions.
^ Jump up to: a b c Competition from other firms who offer other financial asset
s that promise the market rate of return forces the person who is asking for a d
elay in payment to offer a "discount yield" that is the same as the market rate
of return.
^ Jump up to: a b Chiang, Alpha CX. Fundamental Methods of Mathematical Economic
s, Third Edition, McGraw Hill Book Company, 1984.
External links[edit]
Look up discounting in Wiktionary, the free dictionary.
Tutorial on Discount Mathematics
Categories: Actuarial scienceLoans
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