If you sell with deferred payment, invest in a new project, or compare borrowing now with paying later, you are comparing money received or spent at different times.
One million rubles received today and the same amount received in a year have different values for a business. Discounting converts future amounts into present value so that you can compare decisions on the same basis.
Here is what discounting means, which formulas are useful, how to choose a discount rate, and when to use the calculation in day-to-day business decisions.
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What discounting cash flows means
Discounting cash flows means converting future receipts and payments into their value today using a discount rate. It is part of discounted cash flow (DCF) analysis: you bring all future cash flows to one date to assess their value for a decision.
Imagine a customer offers two contract options. The first pays an advance today. The second pays a larger amount four months later. Discounting helps you compare them while accounting for the cost of waiting and the risks involved.
Why future money is worth less
Three reasons explain why money received later is usually less valuable to a business.
First, there is an alternative return. Money received earlier can finance supplies, pay your team, or help you take on another order. For many businesses this is closely connected to cash flow and the risk of cash shortfalls.
Second, there is risk. The farther away the payment date, the more chance that payment, delivery, or the scope of work will change. More risk raises the required return and therefore the discount rate.
Third, inflation and price changes can reduce purchasing power. Even if revenue is stable, the same amount may buy fewer materials and services a year from now.
PV, DCF and NPV formulas
Three formulas cover most practical decisions: the present value (PV) of one amount, the present value of a series of payments (the sum used in DCF), and a project's net present value (NPV).
1) Present value of one future amount:
PV = FV / (1 + r)^n
FV is the future amount, r is the discount rate per period, and n is the number of periods.
2) Present value of a series of cash flows:
PV(cash flows) = CF1/(1+r)^1 + CF2/(1+r)^2 + … + CFn/(1+r)^n
3) NPV, or net present value, is the present value of future cash flows less the initial investment. A common formula sums the discounted flows, including the cash flow at period zero.
| Decision | Calculation | Interpretation |
|---|---|---|
| Compare payment now with payment later | PV of one amount | The larger PV is worth more today |
| Assess a project with several receipts and payments | PV of the flows, then NPV | NPV > 0 meets the required return at the chosen rate |
| Compare two projects of the same duration | NPV reflecting each project's risk | Use consistent cash-flow methods and assumptions |
How to choose a discount rate
The discount rate reflects your business's cost of capital and the project's risk. It is the return you require for tying up money in a project.
Suppose you are deciding whether to take on another job. The estimated margin looks attractive, but you must invest a large amount upfront. If the discount rate is too low, NPV will look more appealing than the cash position warrants.
For a small or medium-sized business, start with the cost of funds actually available to it: a loan, supplier credit, or its own capital. Then consider the risks specific to the project, such as an unreliable customer, difficult logistics, seasonality, contract penalties, and rework.
Business uses for discounting
Discounting is useful whenever a decision involves money arriving or leaving at different times and you need one basis for comparison.
1) Customer terms: advances, instalments, milestones, or incentives for early payment. Comparing PV shows the cost of deferral and helps you justify an early-payment discount.
2) Equipment and investment: buy, lease, rent, or use a subcontractor. Compare the present value of all payments and the effect on working capital, rather than just the monthly bill.
3) Working capital: projects that pay back slowly tie up cash and increase the risk of cash shortfalls. Connect the calculation with regular monitoring of cash flow and financial reports.
If you already keep financial records, you have a useful base for the calculation: actual payments, a plan, and a view of where cash is tied up. See 101's articles on financial accounting of income and expenses (Russian) and the cash flow statement (Russian).
How to calculate a project's NPV
Consider a typical project: you invest today, then receive payments and incur costs during the work. The question is whether the project earns enough at your required rate.
- Choose today's date as the valuation date and set a time step: month, quarter, or year.
- Forecast cash flows by period, separating receipts from payments. Use actual money flows rather than accounting profit.
- Choose a discount rate for the same time step and record your assumptions so you can rerun the calculation.
- Discount each period: CFt/(1+r)^t, where t is the number of periods since the valuation date.
- Add the discounted flows. An initial investment at period zero enters at its full negative amount.
- Interpret the result: NPV above zero means the project exceeds your required return under those assumptions.
Keep management reports next to the model, particularly actual cash flow and working-capital monitoring. They reveal when receipts arrive later or expenses occur earlier than planned. For more context, see 101's article on working capital (Russian).
Common errors and quick checks
A discounting calculation is only as useful as its cash-flow estimates and discount rate. Errors in either can change the decision.
- Mixing profit and cash. NPV is based on cash flows. Profit on paper cannot fund work when the cash has not arrived.
- Picking a rate without a rationale. Later, you may not remember why you chose, for example, 18% per year, making it hard to challenge the assumptions.
- Comparing projects inconsistently. Account for differences in duration and risk, and apply a consistent method to their cash flows.
- Skipping sensitivity analysis. For an important decision, recalculate NPV at two or three rates and with receipts delayed by one period. This shows how sensitive the project is.
With regular use, discounting becomes a practical tool for negotiation, planning, and project selection. Together with performance analysis, it shows both the value of the return and when the money comes back.