Discounting principle explains about the comparison of money value in present and future time.
If person is given option to take 100/- as a gift for today.
If person is given option to take 100/- as a gift after one month.
Normally a person chooses first offer only. Why because “today rupee is having more worth than tomorrows rupee”
Application of discounting principle in business:
In the business, everybody prefers to do cash sale only rather than the credit sale and even they are ready to give cash discount for cash sale. The reason is we will get a rupee today and today’s rupee is more valuable than the tomorrow’s rupee. But In credit sale we will get rupee tomorrow or in the future time and nobody give the discount for credit sale.
We commonly see bank and postal departments adverting that they will give 12% interest for every year on bank deposits what we have invested with them. With this 12% interest for one year, if we want to get 1-lakh rupees after one year, how much we should deposit at present? This question is answered by discounting principle.
In the future if we want to earn 100000/- how much we should invest at present. Example in the bank (100/- @ 12% interest rate of one year)
In this case we should invest at present 92.59 @ 8% interest for one year to get 100/- for the next year.
How to estimate the purchasing value of the Rupee
How often have we heard our grandparents reminisce about the good old days when things were so much cheaper? Everything seems to have been available at a fraction of what it costs today, be it rice, potatoes, mangoes, petrol or utensils. A kilo of sugar that could have been bought for Rs 2 in the 1970's currently costs Rs 40, while a dozen bananas that you could have bought for just Rs 10 about 20 years ago, will now cost you Rs 35. The quantity of a commodity that a rupee used to buy years ago has contracted. In other words, the rupee has lost its purchasing power. The reason for this loss is largely macro-economic and linked to aggregate demand and supply dynamics, government borrowings, exchange rate and interest rates. Typically, the rupee loses its purchasing power when there is a general increase in the economy's price level, technically termed as inflation. Inflation is not only a cause of concern for the RBI and the government, it also severely impacts the value of the investment portfolios and can upset any deferred purchase plans. For example, in 2010, painting your house cost Rs 40,000. You deferred the plan for a year and kept the amount in your savings account. In 2010-11, inflation went up by 9.6% (on an average). So, the expense of the paint job increased to Rs 43,825, but you only have Rs 41,400 in your bank account. Due to the fall in the value of money, you will now need to cough up an extra Rs 2,425 for the same work. Let us look at how you can estimate the purchasing power of money. This concept rests on the theory of discounting, which is the reverse of the compounding theory. In discounting, the amount receivable at some future date is worked back to the current time period. The future amount is discounted to the current period using a rate known as the discounted yield. Say, someone promises to pay you Rs 1,000 a year from now. The interest rate offered by your bank is 9%. Using the bank's interest rate as the discounted yield, you can work out the current or present value of Rs 1,000, which comes out to be Rs 917.43. If, instead, you receive Rs 1,000 now, you could invest it at 9% and after one year, you will receive Rs 1,090.
The concept has varied applications in investment and financial planning. It is used by banks for determining the home loan EMIs and is also used by financial planners for estimating the returns from money back insurance policies, mutual fund SIPs and bond yields. Looking at the value of the rupee, the rate of inflation prevailing in the economy is used as the discounted yield for determining its purchasing power. The formula for discounting is given above.
Over the past 21 years, the inflation rate in the country (as measured by the WPI index) has averaged 6.07% annually. Here's how the purchasing value of Rs 100 has changed over these years. In the above formula, 'CV' is Rs 100, 'i' is equal to 6.07% and 'n' equals 21. So, the value of 'RV' will compute to Rs 29.01. This means that what Rs 29 used to buy in 1990-91 will now cost Rs 100. If the above equation appears complicated.