Explain the Concept of Discounting and Its Importance in the Theory of Investment Expenditure.

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There are trade-offs involved in every economic decisions. When considering whether or not to carry out a capital investment, it is rational for firms to estimate the expected rate of return on investment by comparing the costs of purchasing and maintaining the capital goods and the future expected profits. However, it is flawed to treat the value of a pound that is received in the future to be equal to the value of a pound received today. One reason is that due to rising inflation, the true value of the currency will depreciate over time, and this results in a fall in the purchasing power of a pound. Rational economic agents also tend to value near term benefits more than the long term benefits because of the future uncertainties and risks. This phenomenon is described as time preference. Hence, the concept of discounting plays a significant role to address the issue raised by the change in real values of the resources at different time periods. By taking into account the trade-off between immediate and delayed benefits, it will eliminate the problem of time preference. As there is always a time lag between purchasing the capital goods and generating revenue from the investments, this concept is particularly important in the theory of investment expenditure. Another important consideration is that the money spent on capital investment can actually be used in alternative ways, most often, by lending the resources out to earn interests. So by engaging in a certain capital investment, firms will have to forgo these interests or alternative investment possibilities. Thus, it is vital for them to adjust the anticipated stream of future expected profits to expected present values so as to weigh the costs and benefits of an investment. This can be done by reducing the value of future profits at the discount rate to determine their worth under present valuation. Then the net present value can be calculated by subtracting the total present value of the expected...
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