Discount Rate

The discount rate R is applied in this investment equation 1/(1+R)N to calculate the Present Value of $1 after N periods.

The discount rate can be either:

1. The rate of inflation -which calculates the present value in constant dollars.
2. The adjusted (real) yield rate on T-Bills.
3. The rate of return available on alternative "risky" investment opportunities - Risky as opposed to T-Bills.
4. The average weighted cost of capital of your firm.
5. The threshold rate of return you require from the investment - If the Net Present Value is positive at your threshold rate of return, the rate of return is higher than your threshold.

Adjusted discount rate:

Adjusted discount rate = 1/r (1-e-r)

Because the timing of Cash Flows is Usually Not Discreet - Adjust the Discount Rate To the Half Point.

Spreadsheet NPV functions also fall into the trap of assuming that cash flows are discreet bundles of money that arrive at the start or end of the discounting period.

For example, the hidden assumption (not often appreciated) when discounting the type of cash flow forecasts, is that cash flows arrive at the end of each period.

In the real world this is clearly not true. Many cash flows in business are incurred and collected throughout the year.

For real accuracy use this adjusted discount formula for calculating the present value of cash flows when cash flows are received throughout the period:

You will recall that "e" is the base for natural logarithms. The value is 2.71828182845904.

However it is not really that convenient to work with exponential values.

A very good approximation to adjust for the continuous nature of cash flows is to assume that they take place discreetly but half way through the period.

This will adjust the discount factor like this: 1/(1+r)0.5

Software Links

InvestmentCalc PRO 7.3

Reference Pages

Discounted Cash Flow

Discounted Pay Back Period

NPV

NPV Rule