unwinding of the discount

If I have to pay $2.42 in 2 years’ time and my cost of capital is 10%, how much should I put on deposit TODAY so that I have $2.42 at the end of those two years?

Answer $2. Why? because after 1 year, my $2 will have grown to $2.20 ( $2.00 x 1.10 ) and at the end of another year, that $2.20 will have grown to $2.42 ( $2.20 x 1.10 )

The “1.10” is “1 + the rate of interest ( or cost of capital ) expressed as a percentage.

OK, so now accept that $2.42 payable in two years’ time is the same as $2 today. To make that calculation I take $2.42 and DIVIDE by 1.10. If I do that once, I arrive at $2.20. If I do it a second time, now I arrive at $2.00

OK so far?

Right, I acknowledge TODAY an obligation of $2.00 knowing that I shall have to pay $2.42 in two years’ time. One year later, I’m only one year away from having to make the payment. Because I’m one year closer, I need to “unroll” or “unwind” the discount by taking the $2.00 from the start of the year and unroll that amount by 10% ie by 20 cents.

The double entry? Dr Finance costs, Cr the Obligation account

Another year goes by and I’m facing paying the obligation of $2.42 TOMORROW.

OK, unroll the discount by another year. The balance at the start of this second year was $2.20. Unrolling at 10% is 22 cents and the double entry is Dr Finance costs, Cr the Obligation account. Now look at the Obligation account!

It started at $2.00 two years ago. Then at the end of the first year it was $2.20 and now, at the end of the second year the balance id $2.42

And that, my friend, is what is meant by “unrolling the discount” or “unwinding the discount”

That’s good to know! 🙂