Present Value or Discounting Technique

The concept of the present value is the exact opposite of that of compound value. While in the latter approach money invested now appreciates in value because compound interest is added, in the former approach (present value approach) money is received at some future date and will be worth less because the corresponding interest is lost during the period. In other words, the present value of a rupee that will be received in the future will be less than the value of a rupee in hand today. Thus, in contrast to the compounding approach where we convert present sums into future sums, in present value approach future sums are converted into present slims. Given a positive rate of interest, the present value of future rupees will always be lower. It is for this reason, therefore, that the procedure of finding present values is commonly called discounting. It is concerned with determining the present value of a future amount, assuming that the decision maker has an opportunity to earn a certain return on his money. This return is designated in financial literature as the discount rate, the cost of capital or an opportunity cost. These concepts are elaborated. Let us illustrate the discounting procedure by an example (2.4).

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