What Is Discounting?
Discounting calculator helps you in determining the present value of future cash flows, it is very important not only for investors but for any big, small organization, startups etc.
In layman terms discounting is just opposite of compounding, like in compounding you calculate the future value of your total investments made on a monthly or yearly basis, in discounting we have to evaluate the value of money that we are expected to receive in the future in today’s terms.
Discounting is also known as Present Value of money.
In other words, if you have a present value and you want to calculate a future value, we call it an interest rate(compounding). Whereas, if you have future values and you want to estimate their worth today, we use a discount rate(discounting).
Interest rates and discount rates are two sides of the same coin. Discounting, is the act of determining how much less tomorrow’s currency(rupee) is worth.
Before we begin to understand the core concepts of discounting i want to quote John Maynard Keynes, he said “The importance of money flows from it being a link between the present and the future”.
John Maynard was a British economist, whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments.
As an investor you should know the (TMV) “time value of money” the value of money does not remain the same across time. Meaning, the value of Rs.1000 today is not really Rs.1000, 2 years from now. Oppositely, the value of Rs.1000, 2 years from now is not really Rs.1000 as of today.
Whenever there is motion of time, there is an element of opportunity. Money has to be accounted or adjusted for that opportunity.
For e.g. Your father might have told told you that we used to get 1KG of mangoes in our time at only 5 rupees or may be even less than that. But if you go now to buy the same, this sound unrealistic, reason being with time there is inflation(interest).
That is why one should know, what will be the future investment he made for the retirement is sufficient enough to continue his life post retirement, if you calculate it in today’s term in respect to certain cost(interest) accounted.
Discounting aka present value is the current value of the future payment. For example assume you are expected to receive Rs.100,000/- 10 years from now. PV helps you answer find out the worth of that Rs.100,000/- in today’s terms.
Not only investors but big or small businesses use present value calculations for capital expenditures and routine business planning.
Being able to determine the present value of each potential investment, purchase, or cash flow before committing to it can help you and your company make the best possible decisions.
What Is Discounting calculator Formula?
From above image:
You can determine how much of the total future value you have already accumulated at any given point by using the above equation:
For example let take this question: How much is Rs.100,000/- receivable after 5 years, worth in today’s terms assuming an opportunity cost of 9.5%?
PV = 100,000/(1+9.5%)^5
Answer = Rs.63,522
2.The interest rate for a one-year investment is 8 percent and the future value is Rs.1000. Find the Present value?
Money available in the future is less valuable than the same amount of money available now, so it has to be discounted by a factor to arrive at your money’s current value, which is called ‘Present Value’.
The factor used in this discounting process is called ‘Discounting Factor’.
However, doing this calculation manually takes much time and energy, that is why, we have build a discounting calculator for you, to easily calculate this complex equation.
Not all are math genius (including me), so its better to have resources and tools to save your time.
How To Use Discounting Calculator?
Below calculator will help you in finding the present value or discounting of future cash in today’s term.
Imagine someone owes you Rs.10,000 and that person promises to pay you back after 4 years. If we calculate the present value of that future Rs.10,000 with an inflation rate of 8% using the discounting calculator below, the result will be Rs.7,350
If the interest is getting applied 2 times(half-yearly)4,(quarterly) or even monthly,12, daily, enter that in the number of times that interest is compounded per unit.
Here is the link to use moneycontain compound interest calculator to know the future value of any investment you made.
How Present Value Calculator Can Help?
Let’s look at an example. Assume that you would like to put money in an account today to make sure your child has enough money in 12 years for his higher education.
If you would like to give your child Rs.500,000 in 12 years, and you know you can get 7.5% interest per year from a savings account during that time, how much should you put in the account now? The present value formula tells us:
PV = Rs.500,000/ (1 + 7.5%)^12 = Rs.2,09,927
Thus, Rs.2,09,927 will be worth Rs.500,000 in 12 years if you can earn 7.5% each year. In other words, the present value of Rs.500,000 in this scenario is Rs.2,09,927.
It is important to note that the three most influential components of present value are time, expected rate of return, and the size of the future cash flow. To adjust for inflation in the calculation, investors can use the real interest rate (nominal interest rate – inflation rate).
In other words, money received in the future is not worth as much as an equal amount received today.
Money not spent today could be expected to lose value in the future by some implied annual rate, which could be inflation or the rate of return if the money was invested.
The concept of discounting and Net Present Value:
Apart from individuals for big or small enterprises or firms also uses to account the companies future cash flows with respect to present value.
For e.g In order to determine whether to purchase a new equipment, the firm will take into account the price of the new equipment, the revenue that the new equipment will generate for the firm over a period of time, and the scrap value(how much it will get sold at after the use) of the new equipment.
The company will also take into account like rate of inflation, or rate of return of an alternate investment opportunity. The interest rate, which represents the firm’s opportunity cost of investing in the new equipment.
It will use the interest rate to calculate the present value of the future net income that it expects to earn from its purchase of the new capital equipment.
If the NPV is positive, then the decision taken to generate these cash flows is a sound one, else that decision is to be avoided. If the present value is negative, it is better to not proceed with the investment in new equipment.
We need the ability to calculate whether that stream of future cash flows is worth more than the money we need to invest to buy it or build it. Net present value (NPV) is the tool we use to make that analysis.
The way we look at decisions about whether to fund a project or calculate the value of an asset is to turn that stream of future money into today’s money.
Then we compare that sum of present values to the cost; if the cost is more than the total present value, we don’t do the deal; if it is less, it is considered a good deal.
This is the way projects are analyzed and assessed by a company as to proceed or not, let us understand this with an example.
Suppose you want to open a business of different beverages, however instead of spending money in manpower you came to know about a machine, which can serve the different beverages automatically.
The customer just need to either scratch his cards (debit, credit or pay though an app), than he can choose the beverage by pressing the button and get his favorite beverage(self service).
This was you thought of saving money like (no human resource, so need for giving salary and other small monetary benefits). However, how would you decode whether to purchase machine or have employees to serve it to your customer.
The machine costs Rs.70,000 and lasts 5 years. You estimated that the machine will provide an income of Rs.10,000 per year, including maintenance costs. After 5 years, the scrap value(resold) of the machine is estimated at Rs.8000.
In determining whether to purchase the machine, you will have to calculate the net present value of the present and future income that it receives from purchasing the vending machine.
The present value calculations are shown in table for an interest rate of 8%.
The sum of all the present values of the future cash flow is called “The Net Present Value (NPV)”.
In the 5th year, the Rs.10,000 scrap value is added to the Rs.8,000 in income received from the machine. The total net present value of the machine turns out to be −Rs.30,275.
Because this amount is negative (npv), you may have to avoid going further with the idea..
As Table reveals, the net present value calculations depend on the interest rate which we have fixed at 8%. The higher the interest rate is, the higher the opportunity cost of investing in the machine.
A higher interest rate lowers the present value of the future income earned from capital, making it less profitable.
However, if interest rates fall, the opportunity cost of investing in new capital also falls. The lower the interest rate is, the higher the present value of the future income earned from new capital investment, if you can obtain Rs.7o,000 in loanable funds at less, let’s say 4% interest, you overall will be in benefit.
Remember, you may think i have not taken any loan, its my saving that i am spending to go for a business so no impact of interest rates, but in that case there are other factors like inflation, capital expenditure or other small spending plus time.
You have to pay a certain opportunity cost, the lesser you pay the more beneficial. Another thing would be to decide whether to invest your time and energy there instead of investing that money in any other asset like stocks,index which is less riskier that above business.
How To Use NPV in investment planning?
Now, think about this, What if you can replace the machine with a company? Can you discount all future cash flows that the company earns with an intention to evaluate the company’s stock price?
Yes, you can and this is what you call “Discounted Cash Flow” model.
For instance, let us say you need to decide between investing `1 lakh in a three-year fixed deposit (FD) that pays monthly interest and in a company stock that you plan to resell in three years.
The FD investment represents one negative cash flow now (so no discounting required) and 36 positive cash flows occurring at the end of each month.
The stock investment represents one negative cash flow now and one positive cash flow after three years. Calculate the NPV of both investments using inflation for the Discounting Factor and invest in whichever has higher NPV, provided the NPV is positive.
So all in all whether you are buying a bond or a stock, or Acquiring a company, or Purchasing an income-producing asset, or Undertaking a project and incurring the costs of developing or building the income-producing asset.
Discounting Factor allows us to compare all future cash flows both positive and negative generated by an investment decision and arrive at one consolidated value in the present, which is the Net Present Value (NPV) of all the cash flows considered.
Similarly, if you need to compare a five-year recurring deposit (RD) investment and a mutual fund SIP investment for five years, both the RD and the SIP have 60 negative and one positive cash flows each.
You can use the above method again to decide. Alternatively, use the RD’s stated rate of return to compute the discounting factor for the SIP investment. If the NPV of the SIP investment is positive, SIP is better; else the RD is better.
To calculator your monthly SIP return check Moneycontain Monthly SIP calculator with inflation and know the value of your invested amount easily.
If you want to invest a Lumpsum amount in a Mutual Fund SIP than check Moneycontain Lumsump Calculator with inflation.
One should take informed decisions by doing your own analysis, read and learn new blogs, optimize your investment decisions at all times to become a successful investor.
If you are looking to buy a new home than you should see Moneycontain Home Loan EMI Calculator to better understand the monthly EMI installments as well as interest or property tax and lot more.
You can also check my reviews on best brokers in India here:
Checkout the impact of inflation on your returns as well as your life using moneycontain inflation rate calculator and calculate your future expenses easily.
If, you have liked the content please do share it with your friends or on social media, as sharing do bring the good karma. If you have any questions or feedback you can leave them in comment box below.
Note: Please do not take this as any recommendation, to trade or invest. This is just for reference, to make you understand more about the Discounting calculator, present value and its importance, under no circumstances intended to be used or considered as financial or investment advice, a recommendation or an offer to sell, or a solicitation of any offer to buy any securities or other form of financial asset.
Please do your own research and make investment. Moneycontain will not be responsible for any of your losses at all. The point made is for educational purpose only. All investments are subject to risks, which should be considered prior to making any investments