What is Discount Factor?
The discount factor(DF) allows us to relate a cash flow received in the future to its current value.
Based on a security’s pricing, assume a cash flow of V at a future time T is equivalent to a cash flow of X today.
To achieve X, we multiply V by the discount factor that applies to a maturity T. (i.e., X/Y). You can extract DF from Treasury bills and Treasury bonds.
Example of Discount Factor:
Where r=discount rate, n=time
You may, for example, divide 1 by the interest rate plus 1 to determine the DF for a cash flow one year in the future. The DF would be 1 divided by 1.05, or 95 per cent, for a 5% interest rate. Moreover, you can use your DF and discount rate to calculate the net present value of investment once you’ve computed them. Subtract the present value of all negative cash flows from the total present value of all positive cash flows. Besides, you’ll get the net present value after applying the interest rate.
Why are Discount Factors important?
Understanding the DF is beneficial because it visually represents compounding’s effects over time. Resultantly, this aids in the calculation of discounted cash flow. Moreover, the cash flow drops as the discount rate increases over time, making it a means to describe the time worth of money in decimal form.