Just another 5 year-old who needs help.
In: Economics
The basic motivation is this: would you rather have $100 today or $100 ten years from now?
You’d rather have it today. There are all sorts of reasons why you’d prefer it now (future inflation, ability to invest money and earn returns/interest, uncertainty about the future), but ask any five year old and they’d probably prefer it now too.
Now ask yourself: how much money would they have to pay you in ten years to take that option over $100 today? There must be some number, right? Surely you’d take $1 billion in ten years over $100 today. So you work backwards from that. At some point, you’ll say: “I’ll take X amount, but no lower.” So let’s say that number is $1000. In a sense, that $1000 in ten years is “equivalent” to $100 today.
You can express this equivalence using a percentage called the discount rate. In this case, the discount rate is 25.9%. What that means is that if you were given $100 today, invested that in an account that paid you 25.9% every year, then reinvested it into that same account, you’d end up with $1000 in ten years. This is an example of compounding interest.
If you continue to study this topic, you’ll learn about all the factors that can change. You can adjust the timing of cash flows, the number of payments, what determines your discount rate, etc. But it all starts with this basic idea that a $1 today is worth more than $1 in the future.
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