Discounting is an interesting concept when it comes to Business Economics. This concept is concerned with future costs and benefits arising in future years being worth less to us than should we achieve those same costs and benefits today. This is important in not only the accounting department, but to decide the cost implications of certain management decisions, or whether to invest in something or simply leave it in the bank on a fixed interest rate.
Time preference = money today is better than money tomorrow.
Therefore, all future costs and benefits must be discounted at an appropriate rate of interest. This is referred to as the Discount Rate.
Net Present Value = SIGMA ((St/(1+r) to the power of t)
SIGMA = summation
S = future sum
r = discount rate
t = number of years to elapse before the sum received
Seeing as this concept is a bit awkward to get your head around, lets try a simple example.
A landowner is going to receive a rental income of £5,000 over a 4 year contract. Lets us assume the bank would offer a generous interest rate of 10%. This would therefore make the discount rate 10%. Let us work out the total income for the landlord.
NPV = SIGMA ((st)/(1+r) to the power of t)
NPV = (5000/(1+0.1)) + (5000/(1+0.1)(1+0.1)) + (5000/(1+0.1)(1+0.1)(1+0.1)) + (5000/(1+0.1)(1+0.1)(1+0.1)(1+0.1))
Therefore the contractual sum of income can be seen to decrease in real terms over the period, and this is important when factoring capital investments.