Discounts

When looking at the present value of a payment to be made in, say, 4 years’ time, we discount that four years away value at the company’s cost of capital to find how much that four years away payment is in “today’s” money

Say we need to pay $1,000 in 4 years’ time and the company’s cost of capital is 10%

We would need to invest $683 TODAY to earn compound interest at the rate of 10% to have $1,000 in our hands in four years’ time

After the first year we will have $683 + $68.3 = $751.3
After the second year we will have $751.3 + $75.13 = $826.43
After the third year we will have $826.43 + $82.64 = $909.07
And after the fourth year, just before we settle the obligation, we will have $909.07 + $90.93 = $1,000

So, today, we will record the obligation of $1,000 at its present value of $683

Then as each year goes by, that obligation is one year closer to being paid so we need to unroll (or unwind) the discount

At the end of that first year we shall:

Dr Finance costs $68.30
Cr Obligation $68.30
being the unwinding of one year’s discounted obligation

And at the end of the second year we shall:

Dr Finance costs $75.13
Cr Obligation $75.13

being the unwinding of one year’s discounted obligation

Is that better?