Discounting as Easy as 1,2,3
(By John D. Behle)
(This article is an excerpt from Mr. Behle's book "Discounting as Easy as 1,2,3")
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.
First we enter the figures we have.
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.
This is just a taste of discounting, for more information, see the books "Discounting as Easy as 1,2,3" and "Advanced Discounting and Negotiation Techniques". For some interesting informaiton on partials, see the free article titled "Tall Tails" towards the bottom of the page and various posts related to partials and other paper subjects.
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