Discounting Factor allows us to compare all future cash flows—both positive and negative—generated by an investment decision and arrive at one consolidated value in the present, which is the Net Present Value (NPV) of all the cash flows considered
By Hemanth Gorur
Rajyavardhan has a 10-year-old son who is very inquisitive about money. Wanting to test his son’s savviness, he showed his son a Rs 2000 note and gave him a choice: his son could either opt to take the note immediately; or, he could take it after a month. His son promptly chose the first option.
Investors are familiar with this choice—money in the hand is worth more than the same money available in the future. This is due to the uncertainty the future presents. More importantly, money has the power to earn over time. So it becomes more valuable if available earlier in time.
In the above example, the Rs 2000 if available today can earn interest for one month, leaving you with more money in hand than if the same Rs 2000 were to be available one month into the future. This is called ‘compounding’.
Let us see what happens when the process is reversed.
The concept of discounting and Net Present Value
The reverse process is called ‘discounting’. That is, money available in the future is less valuable than the same amount of money available now, so it has to be discounted by a factor to arrive at your money’s current value, which is called ‘Present Value’. The factor used in this discounting process is called ‘Discounting Factor’. This can be based on various rates like rate of inflation, or rate of return of an alternate investment opportunity. This allows us to compare all future cash flows—both positive and negative—generated by an investment decision and arrive at one consolidated value in the present, which is the Net Present Value (NPV) of all the cash flows considered. If the NPV is positive, then the decision taken to generate these cash flows is a sound one, else that decision is to be avoided.
Using NPV in investment planning
NPV can be a powerful tool in your investment strategy. The basic idea is to denote all invested amounts as negative cash flows and all generated income as positive cash flows. These cash flows could occur at different points in time and could involve various rates of return, yet you can convert all these into their Present Values and compute their NPV to take an informed investment decision.
For instance, let us say you need to decide between investing `1 lakh in a three-year fixed deposit (FD) that pays monthly interest and in a company stock that you plan to resell in three years. The FD investment represents one negative cash flow now (so no discounting required) and 36 positive cash flows occurring at the end of each month. The stock investment represents one negative cash flow now and one positive cash flow after three years. Calculate the NPV of both investments using inflation for the Discounting Factor and invest in whichever has higher NPV, provided the NPV is positive.
Similarly, if you need to compare a five-year recurring deposit (RD) investment and a mutual fund SIP investment for five years, both the RD and the SIP have 60 negative and one positive cash flows each. You can use the above method again to decide. Alternatively, use the RD’s stated rate of return to compute the discounting factor for the SIP investment. If the NPV of the SIP investment is positive, SIP is better; else the RD is better.
Take informed decisions by doing your own analysis. If required, consult a qualified investment adviser, but optimise your investment decisions at all times to become a successful investor.
The writer is co-founder, Hermoneytalks.com and managing partner, Hubwords Media