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Discount Factor FormulaMathematically, it is represented as below, DF = (1 + (i/n) )-n*t where,
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linkArticle Link to be Hyperlinked In the case of continuous compounding formulaThe continuous compounding formula depicts the interest received when constant compounding is done for an infinite number of periods. The four variables used for its computation are the principal amount, time, interest rate and the number of the compounding period.read more, the equation is modified as below, DF = e-i*t Calculation (Step by Step)It can be calculated by using the following steps:
Examples (with Excel Template)Example #1Let us take an example where the discount factor is to be calculated for two years with a discount rate of 12%. The compounding is done:
Given, i = 12% , t = 2 years #1 – Continuous Compounding The formula = e-12%*2
#2 – Daily Compounding Since Daily Compounding, therefore, n = 365 = (1 + (12%/365))-365*2 = 0.7867 #3 – Monthly Compounding Since monthly compounding, therefore n = 12 The calculation of the DF is done using the above formula as, = (1 +(12%/12))-12*2 = 0.7876 #4 – Quarterly Compounding Since quarterly compounding, therefore n = 4 The calculation of the DF is done using the above formula as, = (1 + (12%/4))-4*2 = 0.7894 #5 – Half Yearly Compounding Since half yearly compounding, therefore n = 2 = (1 + (12%/2))-2*2 = 0.7921 #6 – Annual Compounding Since annual compounding, therefore n = 1, The calculation of the DF is done using the above formula as, = (1 + (12%/1))-1*2 = 0.7972 Therefore, the Discount Factor for various compounding periods will be – The graphical representation of the above table will be as follows – The above example shows that the formula depends not only on the rate of discount and the tenure of the investment but also on how many times the rate compounding happens during a year. Example #2Let us take an example where the discount factor is to be calculated from year 1 to year 5 with a discount rate of 10%. Therefore, the calculation of DF from year 1 to year five will be as follows –
Therefore, DF of Year 1 to Year 5 is shown in the below figure – The above example captures the dependence of DF on the tenure of the investment. Discount Factor Calculator
Use and RelevanceUnderstanding this discount factor is very important because it captures the effects of compounding on each time period, which eventually helps in the calculation of discounted cash flow. The concept is that it decreases over time as the effect of compounding the discount rate builds over time. As such, it is a very critical component of the time value of money. It is the decimal representation used in the time value of moneyThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment.read more for cash flow. To determine the discount factor for cash flow, one is required to assess the highest interest rate one can get on an investment of a similar nature. Consequently, investors can utilize this factor to translate the value of future investment returns into present value in dollars. Discount Factor VideoRecommended ArticlesThis article has been a guide to Discount Factor Formula. Here we discuss how to calculate the Discount Factor using practical examples along with downloadable excel templates. You may learn more about Financial Analysis from the following articles –
How is annual discount factor calculated?For example, to calculate discount factor for a cash flow one year in the future, you could simply divide 1 by the interest rate plus 1. For an interest rate of 5%, the discount factor would be 1 divided by 1.05, or 95%. What is the difference between discount rate and discount factor?Whereas the discount rate is used to determine the present value of future cash flow, the discount factor is used to determine the net present value, which can be used to determine the expected profits and losses based on future payments — the net future value of an investment. What is the discount factor that is equivalent to a discount rate?To calculate the discount factor for a cash flow one year from now, divide 1 by the interest rate plus 1. For example, if the interest rate is 5 percent, the discount factor is 1 divided by 1.05, or 95 percent. Which of the term represent the result of subtracting the project costs from the benefits and then dividing by the costs?It is one way of considering profits in relation to capital invested. This is calculated by subtracting the project's costs from the benefits and then dividing by the costs. For example, if you invest $100 and your investment is worth $110 next year, the ROI is (110 − 100) ÷ 100 = 0.1 or a 10% return.
Which process involves selecting information technology projects and assigning resources?Which process involves selecting information technology projects and assigning resources? NPV analysis is a method for making equal comparisons between cash flows for multi-year projects.
Which information is included in a business case project objective high level requirements and time and cost goals?Information in the business case, such as the project objective, high-level requirements, and time and cost goals, is included in the project charter.
What statement is true regarding a return on investment or ROI?What statement is true regarding a return on investment or ROI? It is always a percentage.
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