- Let's talk about the time value of money.
Would you prefer to receive $100 today
or $100 one year from now?
What's your preference?
I think all of us would prefer to receive $100 today.
If the interest rate is, for example, 10%,
receiving $100 today is the same
as receiving $110 a year from now.
In other words,
if I invest that $100 today at 10%,
a year from now, it will be worth $110.
So would I take $100 today or $100 a year from now?
I'll take $100 today.
What about taking $100 today or $110 a year from now?
Well, now we are recognizing
that there is a time value to money.
With a 10% interest rate,
receiving $110 one year from now is the same
as receiving $100 today.
This is called discounting.
$100 today is the equivalent of $110 one year from now
if the interest rate's 10%.
Discounting is the process of explicitly
and mathematically using the time value
of money to make long-term investment decisions.
We discount all of the cash flows
to the present time using the interest rate
so that we can compare them
on a common time basis right now.
In capital budgeting,
we estimate what cash flows are going to be in the future,
and then we discount those cash flows to right now to see
what their cash flow equivalent is today.
Consider, for example, two projects.
Project A will generate a single cash inflow of $100,000
at the end of one year.
Project B will generate a cash inflow of $50,000
at the end of each year for the next two years.
Well, which project would you pay more for,
a cash flow of $100,000 at the end of one year
or $50,000 at the end of each year
for the next two years,
assuming an interest rate of 10%?
If we are going to receive $100,000 one year from now,
how much is that worth today?
We can figure that out using a business calculator
or an Excel spreadsheet.
$100,000 to be received a year from now is the equivalent
of receiving $90,910 today.
Another way to think of this is
that if I invested $90,910 today at 10%,
a year from now, that will have grown to $100,000.
So let's compare project A,
which has a present value of $90,910,
with project B,
which involves cash flows of $50,000
at the end of each year for the next two years.
Again, a business calculator
or an Excel spreadsheet can be used to compute
that the present value of $50,000 each year
for two years is only $86,775
if the interest rate's 10%.
The reason that project B has a lower present value,
even though the total cash flow of $100,000 is the same
as for project A,
is that the second $50,000 payment to be received two years
from now is not worth as much
because it's further away in time.
The capital budgeting process employs
these present value techniques
to identify future cash flows and discount them to see
what their cash flow equivalent is today.