by Discounting principle is a continuation of time perspective & we can say it is a corollary of time perspective.
The old proverb “A bird in hand is better than two in the bush” is a representative of this discounting principle. The worth of a rupee receivable tomorrow is less than that of a rupee receivable today. Since the future is unknown & incalculable, also there is a lot of risk & uncertainty about the future. If the return is same for now & future, then definitely present return will be given importance. So, the future must be discounted both for the elements of waiting & risk of the future. Even if one is certain that he will get some income in the future, it is essential to make a discount in the income because he has to wait for the future, which involves sacrifice. Moreover, inflation may reduce the purchasing power. For making a decision regarding investment which will yield a return over a period of time, it is important to find its net present worth. To know the returns over a period of years to decide over an alternative investment, it is necessary to use discounting principle.
This concept is an extension of the concept of time perspective. Since future is unknown and incalculable, there is lot of risk and uncertainty in future. Everyone knows that a rupee today is worth more than a rupee will be two years from now. This appears similar to the saying that “a bird in hand is more worth than two in the bush.” This judgment is made not on account of the uncertainty surrounding the future or the risk of inflation.
It is simply that in the intervening period a sum of money can earn a return which is ruled out if the same sum is available only at the end of the period. In technical parlance, it is said that the present value of one rupee available at the end of two years is the present value of one rupee available today. The mathematical technique for adjusting for the time value of money and computing present value is called ‘discounting’.
The formula is:
PV = 100/(1+i)
Where,
PV = Present Value
i = Rate of Interest.
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.
