What is a discounted value

Discounting - present value calculation with "aha" effect

Discounting is the calculation of the current value of future payments. Anyone who knows the interest, payments and duration of an investment can use discounting to calculate their present value. This cash value then shows how much seed capital would be necessary before the investment in order to achieve the same return with it.

Discount calculation - bringing future values ​​compressed into the present

Discounting, or discounting, brings a value that lies in the future, compressed into the present. Because the interest effect is taken into account, it is also a method of calculating compound interest.

More on the subject:How to calculate compound interest

Amounts that are converted to today's point in time by discounting allow a better comparison and assessment of investments or credits or loans.

The background to discounting is the interest rate and thus the time factor. Money received sooner is worth more than money received later.

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If you now take the two points in time of an investment or future payment and the interest rate, you can determine the discount factor. The present value is then obtained by multiplying the discount factor by the payment amount without interest.

Discounting - Example of Calculating Present Value

Example: Mr. Miller expects annual pension payments of € 1,000 with an interest rate of 5%.

When calculating the discount, the percentage (5% interest) is first divided by 100 and added to 1. So: 1 + 5/100 = 1.05. The discount factor is then 1 / 1.05. If this is now multiplied by € 1,000, the result for the first interest-bearing payment is a cash value of € 952.38.

In the next year the payment will be discounted twice, i.e. multiplied by 1 / 1.05. That would then amount to € 907.03. After that, it is discounted 3 times (€ 863.84), etc.

For example, if you add three annual payments together, the present value for this period is € 2,723.25. Mr. Müller realizes: This is the money he would need today to invest it for 3 years and with 5% interest in such a way that he receives € 1,000 per year from it.

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This is of course a more theoretical calculation. With this calculation method, however, Mr. Müller can identify the discounted amount that he would need for riskier investments in advance of any financial investments. For example, in the form that he invests the present value risk-free and speculates with the safe interest.

Note on the calculation: Instead of adding up the individual annual values, you can take the discount factor according to the number of years as a power.

Discounting - calculation of alternative investment opportunities

The discount calculation can also be used, for example, to determine the value of one-off payments. And with an interest rate that corresponds to an optimal alternative investment. This discount rate represents the so-called opportunity costs.

More on the subject:Imputed interest rates as a benchmark - examples in the corporate sector

This calculation can be used to compare the value of investments.

Mr. Müller receives an offer from a real estate developer: A property for a purchase price of € 100,000 with the promise of being able to sell it again after 2 years for € 110,000. If you take a discount rate of 5%, the calculation looks like this:

110,000 * 1 / (1.05) 2 = € 99,773.24. This is the current cash value, which at 5% interest results in € 110,000 in 2 years.

The offer seems tempting at first. But after the discounting comes the “aha” effect. Since Mr. Müller has € 100,000 available, he calculates that this sum brings € 250 more with a different investment under the same conditions: 100,000 * (1.05) 2 = € 110,250. And that with probably less effort.

The discounting calculation can also be applied to current expenses. It is the reverse calculation of the compounding, in which the value is determined at the end of payments.

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