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Definition of Discount Factor

Updated on May 31, 2014
Discount Factor Definition
Discount Factor Definition | Source

Definition

Discount factor is a mathematical formula used in the cost-benefit analysis and discounted cash flow analysis to calculate the present value of profits that will be received in the future, commonly known as future cash flows. Discount factor is made of two components, namely discount rate and time. In the aforementioned analyzes, discount factor is denoted by the mathematical expression 1/(1+r)^n, where ‘r’ refers to discount rate and ‘n’ refers to time. Discount rate calculation is the most critical step to obtain discount factor. Analysts use various methods such as the capital asset pricing model (CAPM), weighted average cost of capital (WACC), Gordon model and hurdle rate method to determine the discount rate. Time component (n) of discount factor is an anticipated timeframe of future cash flows.

Decision Making

Discount factor is an essential element for business firms to make decisions on proposed projects. Business firms use discount factor to determine the present value of future cash flows of the proposed projects, which is the central theme of cost-benefit analysis and discounted cash flow analysis. The basic objective is to decide whether a project is profitable to undertake. For instance, a business firm decides to construct a commercial complex at the cost of $1,000. The commercial complex yields long run benefits in the form of rent, which are future cash flows. The business firm uses discount factor to calculate the present value of these future cash flows. If the present value is greater than $1,000, which is the cost of constructing the commercial complex, it is profitable for the business firm to undertake the project.

Financial Transactions Recording

Discount factor renders significant contribution to recording financial transactions. Accountants cannot record future cash flows in the current financial statements due to the cost principle and the revenue recognition principle of accounting, which require that all transactions should be recorded at their original cash values and at the time of transactions. To comply with these principles, accountants use discount factor to calculate the present value of future cash flows and record the present value in the current financial statements as original cash value at the time of transaction occurred.

Research and Analyses

Discount factor, when used for economic analyzes, provides a complete picture of projects proposed. In the process of discount rate determination, cost-benefit analysis or discounted cash flow analysis, analysts are able to figure out unforeseen problems associated with projects, areas to be focused and new opportunities to be pursued.

Limitations

The two components of discount factor, namely discount rate and time are highly uncertain. Discount rate calculation involves various economic factors. Unexpected changes in anyone of the factors affect the accuracy of discount rate. Furthermore, the process of discount rate calculation is complicated and requires great expertise. The time component is equally uncertain, since unexpected events may affect the future cash flows of a project.

© 2012 Sundaram Ponnusamy

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