Discounting Techniques

Abstract

If a firm invests in projects with rates of return down to, but no lower than, say, 10 per cent, then it can ‘discount’ future profits at 10 per cent p.a.: this is then the firm’s marginal investment rate (see Section 4 below for precise definitions of these terms). When assessing the present value of money in a year’s time, one must find the amount that needs to be invested today in order to arrive at the given sum one year hence. For example, suppose there is a cash flow of £110 in year 1: to arrive at this sum a firm would need to invest £100 today at 10 per cent. In other words, the firm should be indifferent between £100 today and £110 in year 1. It follows therefore that the £110 has a value today (‘present value’) of £100. Since we know that £100 at 10 per cent becomes £110 in a year’s time, we can reduce, or ‘discount’, all year 1 cash flows by the ratio 100/110. Similarly, profits in year 2 are twice discounted by the ratio 100/110 to get their present value. For example, profits of £121 in year 2 would have a present value of

Once again, the rationale is that one would need to invest £100 today in order to obtain £121 in two years’ time.