In this article I will not attempt to go into all the elements of discounting. There are three types of cash flows. We will look at the most common which is a “Series of payments”. The other two types are a “Lump Sum payment” and a “Future Series of Payments”. They are easy to learn, but require about a 50 page text to cover efficiently. The intent of this article is to give a basic understanding as well as a few examples.
The keys are as follows.
N = Number, indicating the number of time periods.
%I = Interest rate or rate of return (yield).
PMT = Payment. This is usually a monthly payment, but could be quarterly, annual or some other.
PV = The present value (value at a particular rate of return or yield) or balance.
FV = The future value, generally indicating a value, or balance at a future date. Usually a balloon.
A simple example of discounting involves a series of payments type cash flow. This cash flow is an equal amount of payments over a certain time period – like months. This is the typical amortized loan that we are all used to seeing. With a series of payments we have no future value. When the last payment occurs, the loan is paid in full. The FV value still needs to be entered as a zero to make sure there is not a value left in from a previous calculation. Many loans have more than one cash flow and some calculators will calculate more than one cash flow at a time. The simplest way in the long run is to learn to break the cash flows down. We'll just work with this one cash flow right now – a series of payments.
Let's take the following note or loan. The balance is $10,000 with interest at 10% and a monthly payment of $132.15 per month for ten years or 120 months. We usually enter the PV figure as a negative since we are looking at things through the eyes of a lender. We put out the initial amount, so it is a negative cash flow to us and a negative number. We then receive the payment (and balloon if there is one) so that is a positive cash flow coming in – and a positive number.
Now, to discount the note, all we have to do is substitute the yield we want for the interest rate and then re-calculate for PV or present value. Let's say we want a 14% yield. I enter 14 into the %I register of the calculator and then calculate PV for a resulting value of $-8,511.21
Ok, so let's say we are negotiating with someone and offer $-7,935.26 for the note. Why? Because we always build a buffer in and never negotiate in round numbers. A round number begs to be challenged. A precise looking number looks like it is set in stone and 30 computers worked 30 days to come up with the number. In reality, it is a PFA number – “Plucked From Air”. If someone asks, you could say that your special PFA software derived the number. So, you are negotiating. You settle and agree on $-8250. What is your yield? You know it is better than 14% since it is a lower number. Some would say that's “Good Enough”, but others want to know exactly what their yield is. To do so, use the same process. Enter the PV of $-8250 and solve for the %I or yield. You come up with 14.81% yield or IRR (Internal Rate of Return).
Discounting becomes much more technical and creative also. Let's say you have a seller that is open to a “partial” offer. That is where you only buy a portion of the note or cash flow for a lesser amount. A partial is a technique to acquire more notes while working more creatively to meet a seller's needs. It is far to advanced to cover in this article, but here is an example so you can see the concept. Taking the same note, let's say the seller needs $5000 and we need our 14% yield. We can substitute the 14% for the %I and also the $5,000 for the PV. The payment would stay the same and we can ask the calculator how many payments we would need to buy. The calculator says 50.21 (51) payments.