Discount rates, also known as discount factors, are a critical component of the time value of money. Investors can use discount rates to translate the value of future investment returns into today's dollars. If your investment provides you dividends or interest proceeds over time, you will need to calculate multiple discount rates.
Time Value of Money
One of the basic tenets of investing is that a dollar today is worth more than a dollar tomorrow. For example, say that you have the choice to receive $100 today or receive $100 in a year. During the year, you can invest the $100 received today at a rate of 5 percent. That means you'll have $105 at the end of the year. Given the choice of having $105 at the end of the year or waiting to get the original $100 at the end of the year, you would likely take the $105.
Because of the value difference that timing creates, investors and financial analysts discount future cash flows to translate them into today's dollar value. This is referred to as present value.
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Calculating Discount Rates
The discount rate or discount factor is a percentage that represents the time value of money for a certain cash flow. To calculate a discount rate for a cash flow, you'll need to know the highest interest rate you could get on a similar investment elsewhere. 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.
For cash flows further in the future, the formula is 1/(1+i)^n, where n equals how many years in the future you'll receive the cash flow. In this scenario, the discount rate for a cash flow two years away is 1 divided by 1.05 squared, or 91 percent.
Applying Discount Rates
To apply a discount rate, multiply the factor by the future value of the expected cash flow. For example, if you expect to receive $4,000 in one year and the discount rate is 95 percent, the present value of the cash flow is $3,800. Keep in mind that cash flows at different time intervals all have different discount rates. For example, if you expect an additional $4,000 in two years, that cash flow should be multiplied by the two-year discount rate — in this scenario, 91 percent — for a present value of $3,640.
Finding Net Present Value
Eventually, the discount rates you calculate allow you to determine the net present value of an investment opportunity. To calculate the net present value of an investment, sum the present value of all positive cash flows and subtract the present value of all negative cash flows. For example, say that the investment you're considering requires an initial cash outlay of $7,000 and will provide you two cash flows of $4,000 at the end of year one and the end of year two. At a 5 percent interest rate, the present value of all cash flows is $3,800 plus $3,640 minus $7,000. The net present value of this investment would be $440.