What is the discount factor?

The discount factor is a term used in economics. It is a factor that adjusts the future values ​​of economic parameters to their value in the present. It is a weighting factor of the values ​​of future expenses and income to obtain the net present value of a good or a service. The real value of the dollar will be lower in the future due to inflation, so it is assumed that the discount factor takes values ​​between 0 and 1. For example, with a discount factor of 0.9, an activity that yields 10 units utility in the present, in current situations it would give a utility of 9 units after the period in which the discount factor was calculated.

The discount factor and the net present value

The discount rate is a factor that allows determining the present value of a future flow of money, unlike the discount factor with which the net present value is calculated, which can be used to determine the expected gains and losses based on payments. futures, that is, the net future value of an investment. To do this, the periodic interest rate must first be determined by dividing the annual interest rate by the number of payments expected to be made annually. Then you have to determine the total number of payments to be made. Defining a variable for each parameter, P for the periodic interest rate and N for the number of payments, the formula to determine the discount factor D will be

D = 1/(1 + P) ^N

It is possible to consider multiple periods in which you can have different benefits. In these cases, future values ​​are usually evaluated more than present ones. To simplify, in these cases the factor that must be applied to discount the benefits of the following period with respect to the previous one is a constant value between 0 and 1, the discount factor. The discount factor can be interpreted not as a reduction in relation to future events, but as a subjective probability that the agent will stop acting before the next period, thus ruling out future events; not because they cannot be quantified, but because they may not happen.

If the agent’s evaluation is oriented to the present, he discounts heavily in the future, and therefore the value of the discount factor is small. In a discrete-time model, in which agents use a discount factor b, this is calculated as

b = 1/(1 + r)

where r is the discount rate.

Sources

N. Gregory Mankiw. Principles of economics . Second edition. McGraw Hill, Madrid, 2002.

Omar Alejandro Martinez Torres. Economic analysis . Astra editions, Mexico, 1984.