© 2000 John Petroff
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© 2000 John Petroff |
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C- Discounting (or time value of money)
Future benefits must be discounted (or converted) to their present (or today's) value, before they are summed. Discounting is part of the study of time value of money, or actuarial mathematics, and a complete treatment of it can be found in specialized textbook. Only essentials necessary for this manual are briefly presented here and in the appendix to this chapter.
Before starting the discussion of discounting, it should be mentioned that, for cash flow calculations, there is another approach which is, however, rarely used today. It consists in calculating a certainty equivalent for each future benefit (i.e. cash flow), then these can be simply added together. This is a probabilistic method in which each possible outcome is assigned a probability. A certainty equivalent is the expected value of that dispersion of outcomes (i.e. sum of each outcome multiplied by its respective probability). The method makes it clear that future amounts are uncertain. The approach is not popular because it suffers from the subjectivity of assigning probabilities. Incorporating uncertainty into the discounting process is necessary. It is accomplished by making it part of the discount rate. This is the subject of Section E of this chapter. Let's return to time value of money calculations.
Time value of money studies how amounts of money are made equivalent over time. Converting amounts today into their future equivalent consists in adding interest to principal, i.e. compounding. Converting amounts in the future into today's equivalent consists of charging an interest, i.e. discounting. Thus, discounting is the exact inverse of compounding.
See review questions Q-2C.1 through Q-2C.3
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