You use discounting principles to determine the value of something in the future, compared to its present day value. The reasoning behind the discounting principle is that an amount of money you have in your hands today is worth more than money you have the potential for having at some future time. You would rather have $100 today than wait until tomorrow for the same amount of money.
Discounting Principle Defined
The discounting principle requires you to look at the value of a sum of money in the present day and compare it to the value of the money after an amount of time. You need to do this if you are in a situation where you will use the money at a future date. The value of the future amount of money is known as the present value. To find the present value, you need to discount the amount of interest the money could earn if you were to place it in an interest earning account. The formula used to find the discount factor is PV = Amount/ (1+i). PV means "present value," and "i" stands for the interest on the account.
Saving Money In a Bank
An example of when the discounting principle comes into play is saving money in a bank account that earns interest. If you receive $100 from someone and place it in an account that earns 10 percent interest yearly, you will have $110 in a year's time. But if you wanted to have $100 next year in that same 10 percent interest account, you would need to deposit $90 in the account today.
Determing Value of Future Payments
You also use discounting principles to determine the value of a future payment or future revenue. For example, if a customer wishes to purchase $100 worth of merchandise from you in a year, you will end up with less money than if he were to buy $100 worth of merchandise from you today, as you will not be able to place the money in an account or have it earn interest. To make up for the lost revenue, you may consider increasing the price for future purchases.
The discounting principle is also at play in some types of loans, known as discounted loans. Usually when you borrow money, you borrow a sum, then pay interest on that amount as you repay. You end up re-paying more than the original amount of the loan. With a discount loan, the total interest due on the loan is subtracted from the principal at the start, so you receive the principal minus the interest you will have to pay on the loan. For example, instead of receiving a loan of $5,000 and paying back a total of $5,500, you would receive $4,500 and pay back $5,000. Typically, discount loans are short-term.
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