Discounting

The present value of a sum of money available or due at a later date can be determined by discounting.

With the help of discounting, we can determine the present value of money, i.e. its value calculated for today. We can also say that discounting is the reverse of interest calculation.

During the interest calculation, we calculate the maturity value of the amount of money invested today. To do this, we need to know how much money we invest for what period of time and what the interest rate is. And the interest calculation related to a for the loan shows how much we have to pay back at maturity, if we know the amount of the loan, the maturity of the loan and the interests rate.

To use a very simple example, if we invest $100 today in a one-year term with interest payment due at maturity and an annual interest rate of 5%, we will get back $105 in one year. 

During the present value calculation, we do exactly the opposite. Continuing with the previous example, if we know that we will receive $105 in one year, and we also know that the annual interest rate is 5%, then the present value of $105 due in one year is $100. 

Calculating the present value of the cash flow is a more complex task than the above example. When calculating the present value of an investment for several years, which will generate regular income and expenses in the future, the sums due in the future must first be determined. You also need to know their due date and the interest rate used for the calculations. In the case of the latter, we typically take into account the return of alternative investments with a similar risks. After that, the present value of the sums of money due at different times must first be calculated. Help with this formula used for discounting. After that, by adding these together, we get the present value of the investment calculated for today.