Page 227 - BA2 Integrated Workbook - Student 2017

Long-term decision making

Discount rates

6.1 Changing discount rates

So far we have assumed that a company will use a constant discount rate. This
allows us to use the present value tables. However, in reality discount rates might
change from year to year. Therefore in these instances we cannot use the tables and
instead must calculate each year's discount factor individually using the discounting
formula from the start of this chapter.

6.2 Non-annual periods

In some instances we may have to deal with cash flows which are not in annual
terms. For example, costs might be paid monthly or in 6 monthly blocks. In these
cases we need to pro-rate the discount rate to match the period of the cash flows.

If we are given an annual discount rate, the formula for changing to a non annual rate
is:

(1 + annual rate) (1 / number of periods) – 1

So for quarterly cash flows, we will receive cash 4 times in the year and use the rate:

(1 + annual rate) (1 / 4) – 1

Go over illustration 10 for changing discount rates and try TYU 18

Try TYU 19 for non-annual periods

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