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Discounting

A cost or benefit that occurs in one year’s time is treated as having a lower real value now than an identical benefit or cost today. The corresponding term used to calculate the present value of a flow of future benefits (and costs) is the discount rate. The formula is:

PV = the present value of the benefit or cost occurring in a future year
r = the discount rate
t = the number of years into the future after the base date of analysis
Xt = the benefit or cost in year t
T = the life of the scheme

Discounting often causes discomfort; why should we be prepared to spend less to reduce the risk of a death occurring in 50 years time than to reduce the risk of a death tomorrow? The key point however is to recognise that in any decision we are making some judgement which compares impacts now to impacts in some point in the future. The advantages of discounting are then that at least it enforces consistency and it makes the assumptions explicit. However, there are limitations to both arguments for discounting.



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