how discounting works
the coupon payments found in a regular bond are discounted by a certain interest rate they re then added together with the discounted par value to determine the bond s current value 1from a business perspective an asset has no value unless it can produce cash flows in the future stocks pay dividends bonds pay interest and projects provide investors with incremental future cash flows the value of those future cash flows in today s terms is calculated by applying a discount factor to future cash flows time value of money and discountingit represents a discount on the price of a car when the car is on sale for 10 off the same concept of discounting is used to value and price financial assets the discounted or present value is the value of the bond today the future value is the value of the bond at some future time the difference in value between the future and the present is created by discounting the future back to the present using a discount factor which is a function of time and interest rates a bond can have a par value of 1 000 and be priced at a 20 discount which would be 800 the investor can purchase the bond today for a discount and receive the full face value of the bond at maturity the difference is the investor s return a larger discount results in a greater return which is a function of risk discounting and riska higher discount generally means that there s a greater level of risk associated with an investment and its future cash flows discounting is the primary factor used in pricing a stream of tomorrow s cash flows the cash flows of company earnings are discounted back at the cost of capital in the discounted cash flows model future cash flows are discounted back at a rate equal to the cost of obtaining the funds required to finance the cash flows a higher interest rate paid on debt also equates with a higher level of risk which generates a higher discount and lowers the present value of the bond junk bonds are sold at a deep discount 2likewise a higher level of risk associated with a particular stock is represented as beta in the capital asset pricing model it means a higher discount which lowers the present value of the stock 3