4. Excel For Finance Tips - What is a discount factor ?
Finance is all about money, and working out today's value for money arriving in the future.
- Suppose I am sitting next to you holding £1 and have promised to give it to you in the next 5 seconds.
- what's it worth to you ?
- clearly it's worth £1
- Suppose I promise to pay you £1 in 1 year's time...
- what's it worth to you today ?
- Welll.. a lot of things can happen between now and 1 year's time. I might run out of money, and decide I don't want to pay you back. I may even stop returning your calls or accidentally remove you from my Facebook friends list. There might be inflation that means that what you can get for your £1 in 1 year's time is a lot less.
- That promise is worth less that £1, but how much ?
- Now suppose I promise to pay you £1 in 100 years time...
- what's that worth to you today ?
- Wellll... both you and 1 will be dead unless we're cryogenically frozen, so I think it's fair to say that that's worth absolutely nothing to you today.
The value today of £1 received at each point in time is called a Discount Factor. So we have 3 points in time, and 3 values... now we can plot a graph !
Here's what it looks like in Excel:
... I will explain more about the relationship between interest rates and discount factors in another tip..