By John Sage
To recognize discounted capital DCF you need to recognize a principle called the “discounted buck”.
The principle of “discounted dollars” is important to understanding the Internal Price of Return.
Let’s expect you get a litre of milk at the neighborhood store. It cost you a buck. So what’s it worth. Putting aside the truth that the store owner is most likely not keen to get the litre of milk back from you,it’s substitute value if you drop the milk on the way house,is still a buck. However what about the very same litre of milk,very same time next week. It’s currently a week old. Just how much is it worth? Very little! That’s what we call a “discounted litre of milk“!
The very same process applies with investment returns.
If an investment of a $100,000 is made today and also the very same with $100,000 is returned in one year without rate of interest,and also no capital growth,is it still worth a $100,000?
Possibly not! During that time,it is likely we experienced some price inflation. So we state that the funds have been discounted.So we ask another question: discounted by how much?
One method is to discount rate by the rate of inflation.
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If inflation for many years was 10%,then our $100,000 is currently just worth about $90,000.Utilising the BA-54,we enter $100,000 as the FV,1 for the variety of periods,10% for the i% and also compute for PV.
The response is $90,909.Today Worth of $100,000 paid in one years time thinking an inflation or discount rate of 10% is $90,909.
To define the very same principle in a slightly various way,if we call for at least $100,000 in Present Worth terms,paid to us at the end of one year,thinking an inflation rate of 10% used to determine the discount rate,we should obtain at least $110,000 in one year’s time.
This is because $110,000 Future Worth,discounted at 10% for one year amounts to a Present Worth of $100,000.
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