4. Excel For Finance Tips - What is a discount factor ?

Nick's picture

Finance is all about money, and working out today's value for money arriving in the future.

  1. 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
  2. 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 ?
  3. 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..

Download my spreadsheet that allows you to enter interest rates and it calculates discount factors and plots a graph.