Now you might assume that the value of the company will be infinitely large, provided that it is assumed that positive earnings will flow in every year. However, this is not the case, because earnings that flow to the buyer at a later point in time are worth less in relation to today than earnings that are available immediately. The later the income flows in, the more it is discounted using a discount rate. The nature of this discounting regularly leads to finite income values.
The factor by which an income accruing in the future must be discounted in order to be comparable with today’s income is the reciprocal of ((1+interest rate) to the power of the duration). The higher the discount rate, the greater the effect of discounting future income.
The discount rate to be applied is composed of a base discount rate and risk components.