Basic principle of finance money loses value as time goes on - in other words $100 today is worth more than $100 in a month (assuming ‘normal’ market conditions) one important consequence of this is that you can only compare cash values ‘brought’ to the same point in time (discounted)

Example What would you prefer to get: $50 now or $52 in one year assuming that you get 3% p.a. (per annum) interest? OK, let’s think about it. Assume you choose to get $50 now and hence you can invest your $50 and put it in a bank.

Example cont. So after one year you have =51.5 dollars. Clearly, this is less than offered $52. That is why it’s better to accept $52 in one year.

Now let’s work on the same example backwards. What amount of money would we have to get today so that after we invest it into one year deposit with 3% interest we get $52 in one year from today? We have a proportion:

$1 - $ 1.03 x - $ 52 Clearly, x= 52/1.03= This is present value (PV) of $52 received one year from now.

That’s why we need to get about $50.49 today so that it’s equivalent to getting $52 one year from now. So any amount less than $50.49 received today is a worse deal than receiving $52 one year from now.

Expressing future dollar amounts in today’s dollars is called discounting.