Among the key moments of the successful implementation of the business plan is the calculation of the discount rate. Very often, customers of a business plan have a vague idea of the significance of this parameter, and sometimes they do not even understand why it needs to be calculated.
Discounting is the calculation of the amount of cash flows that relate to the future. In other words, it is the determination of future income at the current moment.
The discount factor makes it possible to estimate the amount of investment taking into account risk and time factor. Time for any project is an important critical factor, since the funds that are currently received are preferable to the money that is expected in the future. After all, “today's” funds can be invested or saved, and receive income or interest.
In order to determine the time interval for the implementation of the project, you must first set the deadline for its completion, equal to the expected number of years (days or months), after which the project will be considered technically unacceptable. Prior to this date, limited, for example, by the period of use of the equipment, the project will be able to make a profit. The correctness of setting timelines is of great importance, which becomes apparent when calculating future costs and benefits in a business plan. Extending or shortening the duration of a project determines the time range in which it is expected to accrue costs and generate revenue. Therefore, the assessment of the duration of the project should be realistic, regardless of how it will increase or decrease its attractiveness.
The value of money taking into account future income is directly included in the analysis of the attractiveness of the project. For this purpose, the discount rate of financial flows is calculated . Such an analysis makes it possible to evaluate the flows of costs and benefits throughout the entire life cycle of the project, reflecting certain flows of finances for each fixed period of time (as a rule, this is a year, a month or five years). Such a reflection of the benefits and costs over the entire life cycle period has a number of advantages, which are that it is possible to clearly identify the main factors affecting the structure of financial flows. This may be the rate of inflation, price changes and uncertainty or risk.
When talking about discounting, in addition to the coefficient, a discount rate is often mentioned. From an economic point of view, this is the rate of return on invested capital. In other words, the discount rate makes it possible to calculate the amount of investments for today to obtain the estimated future income. Therefore, its value has a significant impact on the adoption of the most important (key) decisions. Often, in order to calculate the discount coefficient, the interest rate value is taken as the discount one. However, there is a slight difference between these concepts.
The interest rate is the annual fee for a loan, expressed as a percentage. Repayment of those occurs at the time of repayment of the loan. If, for example, you take 1000 USD per year and the interest rate is 20%, then at the beginning of the term the bank will give out 1000 USD, and at the end it will be necessary to return 1000 USD along with interest on the loan (200 USD), totaling 1200 USD
The discount rate can also serve to express the value of the loan, but in this case, the size of the loan is reduced by the amount of interest on it. If the bank offers to issue a loan in the amount of 1000 USD for a year with a discount rate of 20%, then 800 USD will be issued, and at the end of the term 1000 USD will need to be returned.
So, discounting serves to bring the future amount of money to the current value by reducing it with each given period of the project.
The calculation of the discount coefficient is carried out according to the formula :
Kd is the discount coefficient,
i - discount (interest) rate,
n is the sequence number of the period. For example, for the first year it is 1, for the fifth - 5.