Discounting - Explanation and examples

How much more valuable is it today vs tomorrow?


What is time-discounting?

We’d prefer to have $10 today than tomorrow, or in a year’s time. In reality, this implies that money today is worth more than money in the future. How much less you’d be willing to receive now than in a year, is the discount rate. The principle of the time value of money explains why interest is paid or earned: Interest, whether it is on a bank deposit or debt, compensates the depositor or lender for the time value of money. You might discount for a variety of reasons: to compensate for uncertainty of whether you’ll actually get the reward, and/ or to compensate for the opportunity cost of what you could have been using it for (say, by investing elsewhere).

Examples of discounting

A lot of projects you’d consider running will have benefits that will only come in the future. For example, imagine your company is considering expanding to Asia — it will cost $5 million dollars initially, and will become profitable and earn you $1 million dollars of profit each year for 10 years (at which point it will be useless and have zero resale value). How much is it worth to you to make this investment? Discounting the profits by 5% annually, this means it’s worth a total of $7.7 million, giving you a net profit of $2.7 million.

Sometimes it is best to put off tomorrow what you can do today! If doing something costly doesn’t bring you any benefit to having it done earlier, if you delay until later you’re getting the benefit in the interim. If you’re not going to get fined and you’re certain you will pay it on time (and that’s a big if!), you could delay until just before you have to pay.

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