Financial Discounting – Definition of Discounting: It is the process used for determining the current value of a stream of payment or investment that an individual will receive in the future. In another way, it is the financial mechanism in which a borrower gets the benefit of delaying payment to a lender, for a fixed duration of time in exchange for a fee or charge. The charge or discount is the difference between the actual amount owed at present and the cost that has to be paid in the future date for settling the debt.
The discount is connected to the discount rate, often known as the discount yield. The discount yield refers to the proportional share of the original amount or initial liability owed, which is to be paid for delaying the payment for one year.
Discount yield = Amount charged for delaying the payment for one year/ debt liability.
Most financial and economic models consider that the discount yield is the same as the amount of return that an individual obtains by investing this money in assets carrying a similar risk for a fixed duration covered by the payment. This concept is connected with the opportunity cost (not using the money for a period and covering it by deferring in amount).
How Financial Discounting Works?
The best example for this is the coupon payments that we come across in regular bonds. These payments are discounted with a particular rate of interest and added together by using discount par value to calculate the current value of a bond.
From a business point of view; no value is associated with security unless it can generate cash flow in the future. Bonds generate interest; stock generates dividends and projects returns user the incremental cash flow in the future. The present rate of these future cash flows is determined by applying the discount rate to these cash flows.
If the initial due payment is taken as P, the delay time for payment asked by the debtor is t years and the rate of market denoted by r (on same investment asset). Then, the future value of P will be P (1+r) t, and the discount on it will be:
Discount= P (1+r) t – P
The discount rates used in monetary calculation equate to the cost of capital.
The rate of discount typically applied to various types of firms show significant differences.
- Start-ups asking money: 50–100%
- New start-ups: 40–60%
- Advanced start-ups: 30–50%
- Mature groups: 10–25%
The higher rate of discount for start-ups shows the different limitations they meet, compared to stabilised companies:
- Diminished marketability of ownership or partnership because assets are not traded openly
- A confined number of traders enthusiastic about investing
- Huge risks correlated with start-ups
- Overly optimistic predictions by passionate founders
Another method that calculates the correct rate of discount is the capital asset, pricing model. It makes use of three variables that is essential in calculating the discount rate.
1. Risk-free Rate
It is the rate reflecting the portion of return generated by spending in risk-free assets, for example, government bonds.
It is the measure of fluctuation in the firm’s stock prices concerning the variation in the financial market.
The higher value of beta (greater than one) reflects that the change in stock price inflated in comparison to the rest of the stock in the market.
The lower value of beta (lower than one) reflects that stocks are stoic and not responsive against market fluctuation.
Its value less than zero indicates that the stock is moving in the opposite direction, compared to the rest of the stock in the same financial market.
3. Equity Market Risk Premium
It refers to the return above the risk-free rate that an investor gets on the investment.
Discount rate = (risk free rate) + (equity market risk premium)* Beta
Discount and the Time Value of Money
When a house is on sale with 20% off, it reflects the discount is on the price of the car. This same idea of discounting is used to price and value monetary or financial assets. The present value or the discounted value is the current price of the bond. The difference in the rate between the current and future is due to the discounting the future and present price using the discount factor. The discount factor is the function of interest rates and time.
For instance, assume that the par value of a bond is $1,000 and it is priced at a 20% discount making its value $800. In other words, customers can buy the bond now at a discount and will get the full face value of it at maturity. The difference between them is the return for an investor.
NOTE: Return is the function of risk; hence, the more significant the discount, the larger will the return on it.
Financial Discounting and Risk
Usually, a higher discount reflects the greater level of risk linked with investment and its cash flow in the future. Discounting plays an essential role in pricing the assets or cash flow for the future.
A higher rate of interest paid on mortgages also equates with a greater level of risk, which results in a higher discount and mitigates the current value of the bond. A deep discount is charged on junk bonds. Likewise, the broader level of risk attached with a specific stock is represented by a beta (in the pricing model of capital asset). It means that higher discounts lower the current value of the stock.