One of the fundamental ideas in economics is that a dollar tomorrow is worth less than a dollar today. This seems similar to the saying that a bird in hand is worth two in the bush. A simple example would make this point clear. Suppose a person is offered a choice to make between a gift of 100$ today or 100$ next year. Naturally he will choose the 100$ today.
This is true for two reasons. First, the future is uncertain and there may be uncertainty in getting 100$ if the present opportunity is not availed of. Secondly, even if he is sure to receive the gift in future, today’s 100$ can be invested so as to earn interest, say, at 8 percent so that. one year after the 100$ of today will become 108$ whereas if he does not accept 100$ today, he will get 100$ only in the next year. Naturally, he would prefer the first alternative because he is likely to gain by 8$ in future. Another way of saying the same thing is that the value of 100$ after one year is not equal to the value of 100$ of today but less than that. To find out how much money today is equal to 100$ would earn if one decides to invest the money. Suppose the rate of interest is 8 percent. Then we shall have to discount 100$ at 8 per cent in order to ascertain how much money today will become 100$ one year after.
The formula is:
PV = 100/(1+i)
- PV = Present Value
- i = Rate of Interest.
Now, applying the formula, we get PV = 92.59$
If we multiply 92.59$ by 1.08, we shall get the amount of money, which will accumulate at 8 per cent after one year.
The same reasoning applies to longer periods. A sum of 100$ two years from now is worth:
Similarly, we can also check by computing how much the cumulative interest will be after two years.
Therefore, for making a decision in regard to any investment which will yield a return over a period of time, it is advisable to find out its ‘net present worth’. Unless these returns are discounted and the present value of returns calculated, it is not possible to judge whether or not the cost of undertaking the investment today is worth.
The principle involved in the above discussion is called the discounting principle and is stated as follows: “If a decision affects costs and revenues at future dates, it is necessary to discount those costs and revenues to present values before a valid comparison of alternatives is possible.”
The concept of discounting is found most useful in managerial economics in decision problems pertaining to investment planning or capital budgeting.