Back to basics: discounting
We dive into module 2 of the TC Finance course and examine the process of discounting with the calculations involved.
One of the most important concepts in finance is the concept of the time value of money. This is the idea that an amount of money today is not worth the same as it will be some time in the future.
This concept, explored in Module 2 of the TC Finance course, is an essential one for financial managers to understand, and will aid in scenarios such as appraising a potential project whose cashflows will stretch several years into the future.
If money is invested today, it will grow with interest (or some other form of return) to be a larger amount in the future, as borrowers will pay for the use of a lender’s money.
Calculating future value
The formula used to calculate the final / future value, F, of an amount invested today is:
P = principal invested/present value
r = interest rate or rate of return
n = number of periods principal is invested
Calculating the discount
The process of discounting is simply to do this calculation in reverse and calculate the equivalent today of an amount of money in the future. This uses a rearranged version of the same formula:
There are two different ways to perform the discounting calculation; the first possible way is to use this formula directly, and the second way is to use discount tables.
Copies of these tables are permitted exam material in both TC Finance and TPS Advanced Finance.
The discount tables are filled with “discount factors”, i.e. values of:
for possible r and n values.
The appropriate discount factor would be multiplied by a future value in order to find its present value equivalent.
There are more formulae to deal with more complex scenarios such as annuities (repeated annual cash flows) and perpetuities (infinitely repeating cash flows).
Cumulative discount tables can sometimes speed up discounting calculations involving annuities. These formulae and the use of the tables are discussed further in Module 2 of TC Finance but use the same basic discounting theory that has been covered here.