Discounting: Understanding the Present Value of Future Money

Imagine you’ve won a lottery, and you have two options for receiving your prize. You can either take one million dollars today, or you can wait and receive one million dollars five years from now. Which would you choose? Most people, intuitively, would prefer to take the million dollars today. This simple choice gets to the heart of the time value of money, and more specifically, the concept of discounting.

The time value of money essentially means that money available today is worth more than the same amount of money in the future. Think of it like planting a seed. If you plant a seed today, you give it time to grow, and eventually, it can blossom into something much larger and more valuable, say, a tree bearing fruit. Money works similarly. If you have money now, you can invest it, let it grow, and over time, it can become significantly more. You might invest in a business, put it in a savings account earning interest, or even buy assets that appreciate in value, like real estate or stocks.

Now, let’s flip the scenario. Instead of thinking about money growing, think about working backward. Let’s say you know you will receive one million dollars five years from now. What is that future million dollars worth to you today? This is where discounting comes in. Discounting is the process of determining the present value of a future sum of money. It’s essentially the reverse of compounding, which is how we calculate the future value of money we have today.

Think of it like climbing down a ladder. Compounding is like climbing up, step by step, into the future, watching your money grow. Discounting is like climbing down, step by step, back to the present, figuring out what a future amount is worth right now.

Why is this important? Because money loses value over time due to factors like inflation and opportunity cost. Inflation, simply put, is the general increase in prices of goods and services over time. A dollar today can buy more than a dollar will buy in the future if prices are going up. Opportunity cost is the potential benefit you miss out on when you choose one option over another. If you have money today, you have the opportunity to invest it and earn a return. If you have to wait for the money, you lose out on those potential earnings.

The tool we use in discounting is called the discount rate. This rate reflects the time value of money and the risk associated with receiving that money in the future. A higher discount rate implies a greater reduction in present value. Think of the discount rate as representing the ‘cost’ of waiting for your money. It incorporates factors like expected inflation, the riskiness of the future payment being received, and the return you could reasonably expect to earn on an alternative investment today.

For example, imagine someone promises to pay you $100 one year from now. To figure out what that $100 is worth to you today, you’d apply a discount rate. Let’s say you decide to use a 5% discount rate. This rate might reflect your belief that you could earn a 5% return if you invested money today in a similar risk investment. Discounting at 5% would mean that the present value of that $100 to be received in one year is less than $100. It would be roughly $95.24. This means that receiving $95.24 today is considered equivalent to receiving $100 one year from now, given a 5% discount rate. The calculation is essentially working backward from the future amount using the discount rate, like undoing the effects of compounding.

Discounting is incredibly useful in many financial decisions. Businesses use it to evaluate investments, determining if the future cash flows from a project are worth the initial investment today. Individuals can use it to decide whether to take a lump sum payout now or a series of payments over time, like in the lottery example or when considering retirement options. Understanding discounting helps us make informed financial decisions by allowing us to compare values across different points in time, ensuring we are always comparing apples to apples when evaluating financial opportunities that span over time.