Editing Discounting (section)

{{short description|When a creditor delays payments from a debtor in exchange for a fee}}
{{about||"discounting" in the sense of downplaying or dismissing|minimisation (psychology)||Discount (disambiguation)}}

In [[finance]], '''discounting''' is a mechanism in which a [[debtor]] obtains the right to delay [[payment]]s to a [[creditor]], for a defined period of time, in exchange for a charge or [[fee]].<ref name="Finance_Discount">See "Time Value", "Discount", "Discount Yield", "Compound Interest", "Efficient Market", "Market Value" and "Opportunity Cost" in Downes, J. and Goodman, J. E. ''Dictionary of Finance and Investment Terms'', Baron's Financial Guides, 2003.</ref>  Essentially, the party that owes money in the present purchases the right to delay the payment until some future date.<ref name="Economics_Discount">See "Discount", "Compound Interest", "Efficient Markets Hypothesis", "Efficient Resource Allocation", "Pareto-Optimality", "Price", "Price Mechanism" and "Efficient Market" in Black, John, ''Oxford Dictionary of Economics'', Oxford University Press, 2002.</ref> This [[Financial transaction|transaction]] is based on the fact that most people prefer current [[interest]] to delayed interest because of [[Mortality salience|mortality]] effects, [[impatience]] effects, and [[Motivational salience|salience]] effects.<ref>{{cite book |last1=Chabris |first1=C.F. |last2=Laibson |first2=D.I. |last3=Schuldt |first3=J.P. |title=The New Palgrave Dictionary of Economics |date=2008 |chapter=Intertemporal Choice |name-list-style=amp}}</ref> The '''discount''', or '''charge''', is the difference between the original amount owed in the present and the amount that has to be paid in the future to settle the [[debt]].<ref Name="Finance_Discount"/>

The discount is usually associated with a ''discount rate'', which is also called the ''discount yield''.<ref name="Finance_Discount"/><ref name="Economics_Discount"/><ref name="DiscountRate_Explain">Here, the ''discount rate'' is different from the [[discount window|discount rate]] the nation's Central Bank charges financial institutions.</ref> The discount yield is the proportional share of the initial amount owed (initial liability) that must be paid to delay payment for 1 year.

<math display=block> \text{Discount yield} = \frac{\text{Charge to delay payment for 1 year}}{\text{debt liability} } </math>

Since a person can earn a return on money invested over some period of time, most economic and financial models assume the discount yield is the same as the [[rate of return]] the person could receive by investing this money elsewhere (in assets of similar [[risk]]) over the given period of time covered by the delay in payment.<ref name="Finance_Discount"/><ref name="Economics_Discount"/><ref>{{cite web |url=https://www.smadent.com/discount-calculator/ |title=Discount Calculator - Find discounted product price |last=Kazmi  |first=Kumail |date=February 26, 2021 |website=Smadent.com |publisher=Smadent |access-date=February 26, 2021 |quote=Since a person can earn a return on money}}</ref> The concept is associated with the [[opportunity cost of capital|opportunity cost]] of not having use of the money for the period of time covered by the delay in payment. The relationship between the discount yield and the [[rate of return]] on other financial assets is usually discussed in economic and financial theories involving the inter-relation between various [[market price]]s, and the achievement of [[Pareto efficiency|Pareto optimality]] through the operations in the [[price mechanism|capitalistic price mechanism]],<ref name="Economics_Discount"/> as well as in the discussion of the [[efficient-market hypothesis|efficient (financial) market hypothesis]].<ref name="Finance_Discount"/><ref name="Economics_Discount"/><ref name="Economics_Competition">Competition from other firms who offer other financial assets that promise the market [[rate of return]] forces the person who is asking for a delay in payment to offer a "discount yield" that is the same as the market rate of return.</ref> The person delaying the payment of the current liability is essentially compensating the person to whom he/she owes money for the lost revenue that could be earned from an investment during the time period covered by the delay in payment.<ref name="Finance_Discount"/> Accordingly, it is the relevant "discount yield" that determines the "discount", and not the other way around.

As indicated, the rate of return is usually calculated in accordance to an annual [[return on investment]]. Since an investor earns a return on the original principal amount of the investment as well as on any prior period investment income, investment earnings are "compounded" as time advances.<ref name="Finance_Discount"/><ref name="Economics_Discount"/> Therefore, considering the fact that the "discount" must match the benefits obtained from a similar [[investment|investment asset]], the "discount yield" must be used within the same compounding mechanism to negotiate an increase in the size of the "discount" whenever the time period of the payment is delayed or extended.<ref name="Economics_Discount"/><ref name="Economics_Competition"/> The "discount rate" is the rate at which the "discount" must grow as the delay in payment is extended.<ref name="MathEcon_Chiang">{{cite book |last=Chiang |first=Alpha C. |author-link=Alpha Chiang |title=Fundamental Methods of Mathematical Economics |url=https://archive.org/details/fundamentalmetho0000chia_h4v2 |url-access=registration |edition=Third |location=New York |publisher=McGraw-Hill |year=1984 |isbn=0-07-010813-7 }}</ref> This fact is directly tied into the [[time value of money]] and its calculations.<ref name="Finance_Discount"/>
[[File:Economics of climate change chapter3 discounting curves.png|thumb|right|The present value of $1,000, 100 years into the future. Curves representing constant discount rates of 2%, 3%, 5%, and 7%]]
The "time value of money" indicates there is a difference between the "future value" of a payment and the "present value" of the same payment. The rate of return on investment should be the dominant factor in evaluating the market's assessment of the difference between the future value and the present value of a payment; and it is the market's assessment that counts the most.<ref name="Economics_Competition"/> Therefore, the "discount yield", which is predetermined by a related [[return on investment]] that is found in the different markets in the financial sector, is what is used within the time-value-of-money calculations to determine the "discount" required to delay payment of a financial liability for a given period of time.