Question

1. The discount rate used to calculate the PV of cash flows expected to be received in the future must consider 2 factors. What are they?

Answer 1

The two factors that the discount rate used to calculate present value of cash flows expected to be received in future are:

1. Rate of return expected or the interest rate:

The rate considered is usually a function of the risk free rate that one can earn over a security such as Treasury bills plus a premium for undertaking risk. Thus, the discount factor takes into account an interest rate an investment might earn.

2. Inflation rate:

The discount factor also takes into account the effect of inflation i.e. the rise in the price of goods and services over time which causes purchasing power to diminish or the value of money in terms of goods and services to diminish. The rate of discount may factor an implied annual rate from inflation data.