Discount Factor
Another key term in Finance Theory is Discount Factor. This factor tells you how future values should be discounted to get back to Present Value. Simplest way to understand Discount Factor is how much money I need today to get some pre-determined amount that I need in future. Example - you have a series of liabilities such as tuition fee for your kid which might be fixed at the end of every year, say $30,000. So, you have 4 years of liabilities of $30,000 each at sometime in future and you want to know how much money do you need today to offset these liabilities. Discount factor is your answer to such a question.
Discount factor has 2 dimension attributes. One is time and second is Interest Rate. Based on interest rate, your discount factor changes. A simple logic is higher the interest rate that bank offers, the lower the deposit you need today.
Discount Factor is calculated as 1/(1+r)^n Where n is the number of years and r is the interest rate that bank is offering on fixed deposits for that duration.
Below screenshot shows how discount factor changes with maturity and interest rate.
Discount Factor 2-D Ladder
Now, to answer the original question on how much money you need to have 30,000 in future can be calculated as follows:
Let's say you need to have 30K in year 7, 8, 9, and 10 and the corresponding interest rates that bank offers are 7%, 8%, 9%, and 10%. Now you need to look at the intersection of maturity and interest rate to determine the correct discount factor for multiplication.
Discount factors that match maturity and interest rates are: 0.6227, 0.5403, 0.4604, 0.3855. Now to find total needs today, you just simply multiply each discount factor with the $30,000 that you need.
7 Yr = 18,681, 8 Yr = 16,209, 9 Yr = $13,812, and 10 Yr = $11,565.
So, altogether you would need a total of $60,267.00 today to offset your future liabilities of $120,000.
This is all about power of compounding where money keeps on making money. :)
-Nitin
Another key term in Finance Theory is Discount Factor. This factor tells you how future values should be discounted to get back to Present Value. Simplest way to understand Discount Factor is how much money I need today to get some pre-determined amount that I need in future. Example - you have a series of liabilities such as tuition fee for your kid which might be fixed at the end of every year, say $30,000. So, you have 4 years of liabilities of $30,000 each at sometime in future and you want to know how much money do you need today to offset these liabilities. Discount factor is your answer to such a question.
Discount factor has 2 dimension attributes. One is time and second is Interest Rate. Based on interest rate, your discount factor changes. A simple logic is higher the interest rate that bank offers, the lower the deposit you need today.
Discount Factor is calculated as 1/(1+r)^n Where n is the number of years and r is the interest rate that bank is offering on fixed deposits for that duration.
Below screenshot shows how discount factor changes with maturity and interest rate.
Now, to answer the original question on how much money you need to have 30,000 in future can be calculated as follows:
Let's say you need to have 30K in year 7, 8, 9, and 10 and the corresponding interest rates that bank offers are 7%, 8%, 9%, and 10%. Now you need to look at the intersection of maturity and interest rate to determine the correct discount factor for multiplication.
Discount factors that match maturity and interest rates are: 0.6227, 0.5403, 0.4604, 0.3855. Now to find total needs today, you just simply multiply each discount factor with the $30,000 that you need.
7 Yr = 18,681, 8 Yr = 16,209, 9 Yr = $13,812, and 10 Yr = $11,565.
So, altogether you would need a total of $60,267.00 today to offset your future liabilities of $120,000.
This is all about power of compounding where money keeps on making money. :)
-Nitin
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