Question

What is the “present value” of future returns and how does it relate to the “discount rate”?

How does the discount rate and present value calculation help to explain why young people are more likely to go to college than are older people?

Answer 1

Present Value is nothing but the current value of all the future returns discounted to today. The rate at which the future cash flows are discounted is called the discount rate. Let's assume NPV as the net present Value, F is the future cash flows in years 1 through n and d is the discount rate,

Than

NPV = F/(1+d)+ F/((1+d)^(2))+.......F/((1+d)^(n))

Now more numbers of future cash flows are there the NPV increases and any present cost that we incur can be recovered.

Now let's say college going Fee is X and once out of college yearly earnings is Y,

Let's assume college is just for 1 year and d is the discount rate

Now,

NPV = -X + Y/(1+d)+......Y/((1+d)^(n))

Now as n increases the probability of NPV being positive increases, thus more number of years after college helps in recovering the cost faster and also helps in savings

And hence young people having higher n prefer college as compared to old people