The discount factor formula, a mathematical equation, determines the present value of future cash flows. For instance, an individual investing $1,000 at a 5% annual interest rate for two years would receive $1,102.50 in the future. The discount factor formula provides a precise method to calculate this present value.
Understanding and applying this formula are essential in various financial contexts. It aids in investment appraisal, capital budgeting, and valuation of bonds, loans, and other financial instruments. The formula has been extensively used since the 19th century when it was first introduced to assess the time value of money.