If you are offered £ 100 now or £ 104 in a year's time, is that a good deal?
We can take that £ 100 and lend it to the government (the most secure of lenders) for 4.5% after-tax interest. So the answer is no. After 1 year you would have £ 104.50 rather than £ 104.

What if they offer £ 107? Then we have to say how risky is that? How likely is that they will pay £ 107?
That means how much do we discount that £ 107? If we think they are quite risky we might ask for an extra 5% over above what we would ask of the government. So that means that the £ 107 in one years time is worth now £ 107/1.095 (the safe government's 4.5% plus 5% for risk) or 98p!. The '1.095' is called the discount rate.
So the answer is still no.

The discounted flow of earnings takes the future earnings from an investment and treats them as above. The discount rate being the safe government return plus what we consider a return to justify risk.

Close Window