Question

The concept of discount rate.

Hey guys, I have a question regarding the discount rate.

So, if, for example, someone is saving their money in a saving account that pays EITHER 4% or 10% - then obviously the 10% will be preferable because the future value will be greater, right? Let's say he/she saves $100.

In one year they'll have $110 if they save it at a 10% return or $104 if they save it at a 4% return.

Now, if someone offers you $100 in ONE year, then you should see how much this $100 in ONE year is worth TODAY. Here is where I find it tricky. If the discount rate is 10%, then the value of this $100 TODAY is $90.90, whereas if the discount rate is 4%, the value of this $100 TODAY is $96.15, which is higher.

So what does it basically mean? Why if you invest your money at a higher rate your future value is higher, BUT when you receive money, your present value is considered lower when the discount rate is higher? Of course, the receiver will value the $100 higher when their discount rate is 4%, because it means that if they want to make this value worth $100, they better get more since their discount rate is smaller (i.e. they need to save this $96.15 at a 4% rather than someone who has a discount rate of 10% - they only "need" $90.90 to make a $100).

It's just kinda confusing. Which one is worth more? $96.15 is "better" in monetary values than $90.90, but the rate is lower :S :S :S

Thank you, and sorry for this long post!

Answer 1

If you are investing 10% rate is better, so in that case for 100 in future, after a year, 90.90 is better

Reason : you are investing less that is 90.90 and not 96.15 and getting 100, so 90.90 is better

But

If you are borrowing, then obviously, we want to pay less, so in that case 4% is better

which implies, we will borrow more 96.15 today and not 909.90 and will pay after a year 100

So simple rule = want to invest, see higher rate which implies you have to invest less today as rate is higher

and wnat to borrow, see lower rate, as you can borrow more, pay the same amount

Hope now it is clear. Thumbs up please