By definition, discounting is a method that is used to finance receivables by discounting or selling them. The financier deducts the interest from the maturity value of the note and then gives the proceeds to the receivable holder, who then endorses the receivables note and delivers it to the bank. Discounting is the act of determining the present value of future cash flows. In other words, it determines how much less tomorrow’s dollar is worth since one dollar today is worth more than one dollar tomorrow.

The discount is usually associated with a discount rate, which is also called the discount yield. The discount yield is the proportional share of the initial amount owed that must be paid to delay payment for one year.

The “Time Value of Money” indicates there is a difference between the future value of a payment and the present value of the same payment. The rate of return on an investment should be the key factor in calculating the difference between the future value and the present value of a payment. The discount yield is used within the “Time Value of Money” calculation to determine the “Discount” required to delay payment of a financial liability for a given period of time.

To calculate the present value of a single cash flow, one plus the interest rate divide it for each period of time. It is expressed mathematically as:

Present Value = Future Value/(1+interest rate) raised to the n power.

PV is the value at time=0

FV is the value at time=n

i is the rate at which the amount will be compounded each period

n is the number of periods (not necessarily an integer)

For example: To determine the discount, calculate present value using $100 as future value, 12% as interest, and time is 5 years.

Present Value = 100/ (1+ 0.12) to the 5^th power = $56.74

The discount is the difference between present value and future value which results in $43.26.

Sources:

http://financial-dictionary.thefreedictionary.com/discounting

http://www.yourdictionary.com/finance/discounting