Discount Factor?

Hello all. First post here! I was wondering if someone could tell me what a discount factor is and how it is calculated. Below is a chart that has the discount factors but i don't get the 0 part.

Discount factor – The number that brings the future cash flows back to year 0. In other words, the factor used to determine the cash flows' present value (PV).

year 0 is the point in time at which you would be starting the cash flow.

ie if i were to buy the share now, what is the present value of the future stream of dividends.

assume a discount rate of 10% and a div of 10p.

that div of 10p would only be worth 9p (give or take) in todays money.

the discount rate is usually the % return on a largely risk free investment (eg treasury bills or the like)

year 0 is just a mathematical way of stating "NOW".

hope this helps, im trying my best to forget all my studies...



fc

Ah ok. So when doing analysis on a company how do you derive the discount factor? Sounds like inflation is factored in when trying to come up with the discount factor. Is this correct and is there anything else thats used when determining the DF? I used to love Fraggle Rock. lol

Thanks for the help.

The discount factor will usually be derived from the hurdle rate that the company sets which determines whether a potential project will be acceptable or not (this is along the lines but somewhat different to what FC was referring to above as "largely risk free"). If the normal/ core business of a company returns say 10%pa & 2 potential projects A & B are each estimated to give an annualised rate of return over the same projection period (& given the same risk to capital) of say 9% & 11% resp., then all things considered only B would be chosen. Project A wouldn't be chosen as the capital involved could be earning 10% in the normal business...

The DF will be set depending on a number of factors such as say capital strain, inflation & interest rate conditions, exposure to risk, project term, BE point, business requirements, etc., etc.

In your above example the DF looks like it's derived from a hurdle rate of 8%, where the discount factor is calculated as:

DF = [1/(1+Hurdle Rate)]^n

so for cashflow on the 1st anniv the DF would be (1/1.08)^1 = 0.926, on the 2nd anniv it would be (1/1.08)^2 = 0.857.....

Taking a simple example of a 100k goverment bond redeemed @ par in 5 years paying 10% coupons the NPV (using a hurdle rate of 8%) of all the cashflows would be;

NPV = -100000+10000*DF(1)+10000*DF(2)+10000*DF(3)+10000*DF(4)+10000*DF(5)+100000*DF(5)
NPV = 7985

You can see that this "project" would be viable as under the hurdle rate the net present value (i.e the discounted future profit) is positive. The +ve result above should be naturally expected as the coupon rate is greater than the hurdle rate & we assumed purchase at issue (& therefore at par), however if purchase was not at issue & the price most likely not at par then it would be a more applicable exercise....