If we see the discount factor tables on the first pages of the notes we see that every year the discount factor is decreasing and the longer the period the more decreasing the cost of capital would be...
If the discount factor of a project is 10% then in Year 0 discount factor is 1, but in Year 1 it is 0.909 then in Year 2 it is 0.826 and 0.751, and so on!
My question is that why the interest rate (or cost of capital) is decreasing each year?
What is the purpose of using the discount factor tables because they are just only estimates and could be wrong if the general inflation rate in the economy is changing because it is the inflation rate which causes the interest rate to be higher or lower (true?)
Secondly, I have a misunderstanding regarding the real return rate in the Fisher model could you please tell me what is this rate used for and why do we assume that it kept constant?
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Interest rate
5y ago#1The interest rate is not changing!!!!
The discount factor is used to remove the interest and the more years there are then the more interest is removed (by multiplying by a lower discount factor).
I suggest that you watch me Paper MA lectures on interest and discounting, because this is revision from Paper MA.
As far as the real cost of capital, the relevance of this is all explained in my Paper FM lectures on investment appraisal with inflation.. The lectures are a complete free course for Paper FM and cover everything needed to be able to pass the exam well :-)
Sorry I didn't mean to say that the interest rate is changing but rather what is causing the more interest to remove in more years such as if the discount rate is 10% then the discount factor in Year 1 is 0.909 and in Year 2 it is 0.826 and 0.751 and so on.
If the discount factor in Year 1 is 0.909 from the interest of 10% (or 0.1) then it means that 0.091 x 100 9.1% is the interest that the company is to be paid so we are discount cash flows after removing the interest os 9.1%?
Is it correct that interest is discounting more as there are more years but what is causing the interest to be increasing?
5y ago#3That is effectively the case (although we never calculate it that way).
If there are more years, then the rate of interest is not changing, but it means there are more years of interest to be removed.
Again, have you watched the Paper MA lectures on interest and on discounting?
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