## Discounting (Present Value) Techniques — Overview

Discounting techniques consider the time value of money: future cash flows are discounted to their present value before being compared. They are also called Present Value techniques.

### The five discounting methods

1. Net Present Value (NPV)

2. Internal Rate of Return (IRR)

3. Profitability Index (PI)

4. Discounted Payback Period

5. Modified Internal Rate of Return (MIRR)

### What discount rate should be used?

The discount rate is the desired / expected rate of return — theoretically the return the firm would have earned by investing the same funds in the best available alternative of equal risk (the opportunity cost of capital).

Because identifying the true best alternative is hard in practice, firms use proxies:

A minimum required rate that all capital projects must clear (e.g., an industry average or the cost of other opportunities).
Most commonly, the firm's overall cost of capital / Weighted Average Cost of Capital (WACC) — the cost incurred (or expected) in raising the funds needed for the investment.

> Key idea: the discount rate represents the return the project must beat to add value for shareholders.

⚠️ Common exam mistakes

Confusing the discount rate (an input you choose, e.g. WACC) with the IRR (an output the project generates).
Assuming the discount rate is always given; in many problems you must use WACC as the discounting rate.
Forgetting that all discounting techniques rest on the time-value-of-money principle, unlike payback and ARR.

Reference:

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Discounting Techniques & Choice of Discount Rate

⚠️ Common exam mistakes