Discounting
Discounting is an estimation of expected cash flows, considering the change in the money value in the estimated period. This method helps to find out the present value of the planned receipt, which are expected in the future. As an important element of business, discounting is used to improve the efficiency of operations and pricing strategies.
What is a Discounting
In line to the idea of the time value of money, a certain money amount in the current moment is worth more than the same money amount in the future. The discounting allows the company to compare the price of cash now and in the future, and to assess the profitability and risk of planned cash transactions.
Discounting plays a significant role in pricing issues needed to assess future financial prospects of the company. Companies should optimize the discounting process from time to time, keeping it simple and consistent with overall pricing objectives.
To reveal the current value of bonds, the coupons are discounted by a certain interest rate and summed with the discounted par value. Each asset have to be profitable, otherwise it is useless for business. Dividends and coupons are additional expected cash streams for an investor. As an example, the current market price of bonds is determined by discounting future interest payments. The future money value in present term is measured with discounting factor.
Discounting of assets
In determining the value of financial assets, the same principle applies as in the sale of a house with a discount, for example.
The discounting factor is an important criterion, includes a function of time and interest rates. Not without the help of a discounting factor, the divergence in value between the future and the present is determined.
As an example, when an investor buys a bond with 10% discount, which is $900, he will take a profit of $100, because he will get the full value of the bond at maturity (the par value of this asset is $1,000). The greater the discount, the greater the potential profit, but it is a function of risk too.
Risks of a Discounting
By and large, a high discount point out a high degree of risk connected with receiving money in the future. Discounting is considered the central method of estimating these expected money flows.
Using a discounted cash flows pattern, earnings of the company are discounted back to the cost of capital. It means that future cash flows are discounted back at a rate equal to the cost of obtaining the funds required to finance the cash flows.
It should be considered that the higher the interest rate on any debt, the higher the degree of risk, which leads to a higher discount and reduces the present value of the bond.
A deep discount can be applied to junk bonds, for example. Similarly, the higher the risk factor of a certain stock, the higher the discount is assumed, and the more the stock's present value declines.
