Fundamental Financial Concept: Discounting

Definition of Discounting

In finance, Discounting is the form of mechanism which allows the debtor to delay the repayment of debt over a predetermined time to a creditor with exchange of charge or fees, particularly the debtor purchases the right that approve him to delay the date of the payments until some future date.

• Discounting comes with discounting rate, which is known as discount yield, which is the proportional share of the debt initially owed by debtor, amount that the debtor is bound to repay to delay payment for one year.

Discount yield = "charge" to delay payment for 1 year / debt liability

• Discounting is the method that determines the present value of the payment or a stream of payments that the creditor is going to receive in the future. Given the time value of money, a dollar carries more worth than it would be tomorrow given its capacity to earn interest. Discounting implemented to decide the present value of these future payments.

Books on Discounting

Book 1:

Compounding and Discounting Tables for Project Analysis: With a Guide to Their Applications By James Price Gittinger (published by World Bank Publications, 1984)

Book 2:

Discounting and Intergenerational Equity By Paul R. Portney, John P. Weyant (published by Routledge, 2013)

How Discounting works?

Here is a practical example of discounting discussed below,

To make out the present value, a person has to multiply the amount by a discount rate; this is the opposite of compounding, for example, suppose an investment of $1,000 is compounded at an annual interest rate of 10%, which will become $1,610.51 in coming five years. But reversely, the present value of $1,610.51 can be realized while calculating the annual discount rate of 10%, which means that in recent time investment of % 1,000, will acquire the amount of $1,610.51 in five-year future.

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