It is not the 20 percent savings you got by buying a new washing machine on Black Friday last year. A discount rate is a way of accounting for the fact that dollars in the future are not quite the same as dollars you have right now.
You know this, don’t you? Imagine I offered to give you a dollar right now, or a dollar a year from now. You don’t have to think hard about that decision, because you know instinctively that the dollar that’s right there, able to be instantly transferred into your sweaty little hand, is much more valuable. It can, in fact, be easily transformed into a dollar a year from now, by the simple expedient of sticking it in a drawer and waiting. It can also, however, be spent before then. It has all the good stuff offered by a dollar later, plus some option value.
Even if you’re sure you don’t want to spend it in the next year, however, a dollar later is not as good as a dollar now, because it’s riskier. That dollar I’m holding now can be taken now, and then you will definitely have it. If you’re counting on getting a dollar from me a year from now, well, maybe I’ll die, or forget, or go bankrupt.
The point is that if you’re valuing assets, and some of your assets are dollars you actually have, and others are dollars that someone has promised to give to you at some point in the future, you should value the dollars you have in your possession more highly than dollars you’re supposed to get later.
The rule for establishing an exchange rate between future dollars and current ones is known as the “discount rate.” Basically, it’s a steady annual percentage by which you lower the value of dollars you get in future years.
All you need to remember is two things: the longer you have to wait to get paid, the less that promise is worth to you today. And the higher the discount rate you apply, the lower you’re valuing that future dollar.
Megan McArdle, “Public Pensions Are Being Overly Optimistic”, Bloomberg View, 2016-09-21.
June 29, 2018
QotD: What is a discount rate?
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