The Need for Discount Rates
Some businesses evaluate profitability by calculating the net cash flow they receive from a project on investment. For example, the net cash flow from an investment that costs $500 and will bring in $700 is $200.
The problem with calculating profitability this way is that it doesn't consider the time value of money. Discount rates help investors and managers more accurately calculate profitability by finding the present value of an investment. Under the present value cash flow method, the investor calculates a distinct discount rate for each cash flow the business receives.
Discount Rates in One Year
To calculate a discount rate, you first need to know the going interest rate that your business could get from investing capital in an investment with similar risk. You can then calculate the discount rate using the formula 1/(1+i)^n, where i equals the interest rate and n represents how many years until you receive the cash flow.
For example, say that your company can always invest cash in bonds, which pay 3 percent interest. The discount rate for a cash flow in one year from a similar investment would be 1 divided by 1.03, or 97 percent. Multiply the discount rate by the cash flow to calculate the present value of the cash flow. For example, if you expect to receive a $1,000 cash flow in one year, the present value of the cash flow is $970.
Discount Rates in Other Years
If you expect to receive another cash flow from your investment, you need to calculate a separate discount rate. Even if the cash flow is the same, the discount rate is not. For example, say that you expect to receive another $1,000 at the end of year two. The discount rate would be 1 divided by 1.03 squared, or 94 percent. That means that the present value of the cash flow in year two is $940. You would follow the same pattern for a $1,000 cash flow in year three: 1 divided by 1.03 to the power of three is 92 percent, so the present value of the cash flow would be $920.
Net Present Value
Once you've calculated the present value of all cash flows with appropriate discount rates, you can find the net present value of your investment. The net present value is the sum of positive cash inflows less cash outflows. For example, say that your initial cash outlay for an investment is $2,000, your interest rate is 3 percent, and you'll receive a $1,000 cash inflow at the end of year one, two and three. The net present value is $970 plus $940 plus $920 less $2,000, or $830.