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The Discount Rate

29 April, 2015 - 16:14

The time value of money can be easily quantified at a personal level. A person can ask herself, "What do I prefer, 100 euros today or XXX euros in a year from now?" When she finds the amount that makes her "indifferent", then she can calculate easily her Personal Discount Rate. Assume that given the question, "100 euros now or 120 euros in one year from now," a person replies, "it's all the same to me". Then this person's Yearly Personal Discount Rate (YPDR) is calculated as

   YPDR = (120/100)-1 = 1,2 - 1 = 0,2 = 20%

and in general terms

YPDR = (Equally preferred value in a year / Value today)-1

Note that YPDR quantifies together the effects of all the reasons given above that lead to "money tomorrow" being worth less than "money today".

If a person has calculated his own YPDR honestly, carefully, and rationally, and has tested it over a period of time for stability of preferences, he can then use it as a tool to assist him in taking economic decisions than involve different amounts and timings of money (to be given or to be received). Essentially, by using the discount rate, we can calculate what amount of money received or given today is -for us- equivalent with an amount of money to be received (or to be given) in the future.