Among the key moments of successful implementationbusiness plan is the calculation of the discount rate. Very often business plan customers have a vague idea of the significance of this parameter, and sometimes they do not even understand why it should be calculated.
Discounting is the calculation of the amount of cash flows that relate to the future of the time. In other words, this is the definition of future revenues for the current moment.
The discount factor allowsto estimate the value of investments taking into account the risk and time factor. Time for any project is an important critical factor, since the money that is currently received is more preferable to the money that is expected in the future period. After all, "today's" funds can be invested or saved, and receive income or interest.
In order to determine the time intervalof the project, it is necessary to preset the deadline for its completion, equal to the expected number of years (days or months), after which the project will be considered technically unacceptable. Before this date, limited, for example, the period of use of equipment, the project will be able to make a profit. The correctness of setting time boundaries is of great importance, which becomes obvious when calculating future costs and benefits in the business plan. Extending or shortening the duration of a project determines the range of time that costs are expected to accrue and income is expected. Therefore, the evaluation of the duration of the project should be realistic, regardless of how much it will increase or decrease its attractiveness.
The value of money in the light of future incomedirectly enters into the analysis of the attractiveness of the project. For this purpose, the discounting factor of financial flows is calculated. Such an analysis provides an opportunity to assess the flow of costs and benefits throughout the life of the project, reflecting certain financial flows for each fixed period of time (usually a year, a month or five years). Such a reflection of benefits and costs over the entire lifecycle period has a number of advantages, which are that it is possible to clearly identify the main factors that affect the structure of financial flows. This can be the level of inflation, price changes and uncertainty or risk.
When talking about discounting, in addition tocoefficient is often referred to as a discount rate. 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 to date to obtain the estimated income in the future. Therefore, its magnitude has a significant impact on the adoption of critical (key) decisions. Often, in order to calculate the discount factor, the interest rate is taken as the discount. However, there is a slight difference between these concepts.
The interest rate is the annual fee for a loan,expressed as a percentage. Payment of those occurs at the time of repayment of the loan. If, for example, to take 1000 USD for a year and the interest rate is 20%, then at the beginning of the period the bank will give out 1000 USD, and upon its completion it will be necessary to return 1000 USD together with interest on the loan (200 USD), total - 1200 USD.
The discount rate can also serve tothe expression of 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 given on hand, and at the end of the term it will be necessary to return 1000 USD.
So, discounting serves to bring the future amount of money to the value for the current moment by reducing it with each given period of the project.
The discount factor is calculated using the formula:
Kd is the discount factor,
i - discount (interest) rate,
n is the sequence number of the period. For example, for the first year it is equal to 1, for the fifth year - 5.