What Is a Discounting Factor?
The discounting factor is the amount that a future sum of money must be multiplied by to calculate its value at the present time. This calculation is a product of the time-value theory of money that states that money loses value over time. To perform the equation for the discounting factor, the discount interest rate, which will be affected by inflation, and the time in years between the future date and the present must both be known. In most cases, the factor is used to calculate what a dollar in the future will be worth in the present time.
There is an old adage that says that a dollar today can't buy nearly as much as it did in the past. That is because of the time-value theory of money. A dollar will always be worth more in the present time than it will be in the future according to this theory. For that reason, investors can use the discounting factor to try and judge just how much promised money in the future is actually worth to them in the present time.
Calculating the discounting factor requires knowing both the discount interest rate and the time in years between the future time being studied and the present. For example, imagine that the interest rate is five percent and the future time in question is two years from now. The pertinent equation states that the present value is equal to one plus the interest rate, which is raised to the power of the time in years, and finally divided by 1.
In this case, the interest rate of 5 percent, or .05 for mathematical purposes, is added to one, yielding a sum of 1.05. This sum is then raised to the second power, since the time is two years in the future. The resulting discounting factor of 1.1025 is then divided by one, which yields a quotient of 0.907. Using that projected inflation rate, this means that one dollar in the future is worth about 91 cents in the present.
By doing simple multiplication, the discounting factor can then be used to measure the value of any future sum of money in the present day. Using the example above, $1,000 US Dollars (USD) two years from now would be worth approximately $910 USD. For that reason, investors might consider it wiser to take $1,000 USD and invest it now rather than wait on a promised $1,000 USD return down the line.
Discuss this Article
Post your comments