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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)
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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.
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Example cont. So after one year you have 50+1.5=51.5 dollars. Clearly, this is less than offered $52. That is why it’s better to accept $52 in one year.
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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:
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$1 - $ 1.03 x - $ 52 Clearly, x= 52/1.03=50.49. This is present value (PV) of $52 received one year from now.
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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.
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Expressing future dollar amounts in today’s dollars is called discounting.
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