Discounting is a financial mechanism in which a debtor buys the right to delay payments to a creditor for a certain amount of time, usually in exchange for a fee. The discount is the difference between the original amount owed and the amount that will be paid in the future to settle the debt.
The discount is usually associated with a discount rate, which is called the discount yield. The discount yield is the amount owed as a proportion of the initial amount owed that must be paid to delay payment for 1 year. In other words, it is the amount needed to be paid to delay payment for 1 year/debt liability. It is also the rate at which the amount owed must rise to delay payment for 1 year.
The opportunity cost of not having access to funds for some time is referred to as the discount yield. Most economic and financial models assume that the discount yield is equal to the rate of return that an individual could receive by investing in other assets of similar risk. The relationship between the discount yield and the rate of return on other financial assets is often discussed in terms of economic and financial theories involving the interrelation between various market prices and the achievement of Pareto optimality. Additionally, the efficient market hypothesis is often used in conjunction with the discount yield to discuss the relationship between the two concepts.
When someone delays paying a current liability, they are effectively compensating the person they owe money to for the lost revenue that could have been earned from an investment during the period of the delay. The rate of return, or “discount yield”, is what determines the size of the discount, not the other way around. This yield is usually calculated as an annual return on investment. Because an investor earns a return on both the original investment and any income from prior periods, investment earnings are “compounded” over time.
It is important to remember that the “discount” should be proportionate to the benefits achieved from a similar investment. Therefore, the “discount yield” should be used as a negotiation tool to get a larger “discount” when the payment period is delayed or extended. The “discount rate” is the rate at which the “discount” will grow as the delay in payment gets longer. The time value of money is a key concept in finance that dictates how much future payments are worth in present terms. The market’s assessment of the difference between the future value and present value of a payment is what determines the rate of return on investment, making it a crucial factor to consider when evaluating opportunities. The “discount yield” is the return on investment that is used to determine the amount of money required to delay payment of a financial liability for a given period of time. This yield is found in the financial markets and predetermined by related investments. Using the discount yield in time-value-of-money calculations allows for an accurate determination of the amount of money “discounted” when payment is delayed.