Financial Math 2
Now that we know how to compound we need to learn how to discount. Discounting is one of the most important concepts in finance because it allows us to calculate the value of different sums of money at different points in time.
Consider the following...
I offer you $100 dollars today or $100 dollars a year from now. Which do you choose? Of course, you would rather have the $100 now. Money now is worth more than money later.
Now let's say I told you you could earn a 5% return on any money you invest for one year (no risk) and I offered you $100 today or $105 in the future. In our simplified universe, you would be indifferent to money now or money later because if I gave you the $100 now you would simply invest it at 5% and it would be worth $105.
So if I told you the following...
The risk-free rate of interest is 10%, I am willing to give you $110 in one year or some amount today. What is the amount I would need to give you today so that you would be indifferent to the two options?
In order to solve this question, we will find the present value of the $110 in one year.
PV = present value
FV = future value
r = growth rate / interest rate
n = number of years
By changing each variable you can find the present value of any amount.By using our compound interest math we can find the FV of any amount meaning we can effectively move money through time.