# The Importance of Present Value to Corporate Finance

The concept of present value lies at the core of finance. Every time a business does something that will result in a future payoff or a future obligation, it must calculate the present value of the future cash inflow or outflow. Understanding the concept of the time value of money is crucial, whether you are managing a laundromat or a multimillion dollar corporation -- or even just balancing your checkbook.

## Future Payoff

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Simply put, money at hand is always more valuable than a future payoff. Even if there is zero risk of being unable to collect a future payment, receiving money sooner is to your advantage, since you can place it in a bank and receive interest. When interest rates are 10 percent, for example, receiving \$100 today is the equivalent of getting \$110 in a year. In the first case, you can place the \$100 in a bank and receive \$110 in a year. The formula for calculating the present value of a future payoff is: Cash Flow divided by (1+ interest rate). The present value of \$110 in one year, where interest rates are 10 percent, equals \$110 divided by (1+10%), or \$110/1.1 = \$100.

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## Risk

In business, very few, if any, future payoffs are certain. No matter how confident you are of a future receipt, there is always the chance that the money may not come in. If, for example, you have the option to receive \$100 from a buyer of your goods now or receive \$110 from that customer in a year, the two options are not equivalent unless this party is a bank or the government. The first option is far superior, as it involves no risk; you're essentially guaranteed to end up with \$110 by placing the \$100 in a bank now and waiting a year. In the second case, there is a chance you may get less than \$110 in a year or get nothing at all.

## Discount Rate

Since money expected from a third party carries a higher risk than money deposited in a bank, this risk must be somehow quantified. In business finance, this is done through the discount rate. Instead of using the interest rate offered by the average bank, business people use a higher rate, also known as the discount rate, when calculating future, risky payoffs. The higher the risk, the greater the discount rate. Money expected from a reliable borrower may carry a discount rate of 15 percent, for example, while funds to be received from a risky client may have a 20-percent discount rate. A \$115 payment anticipated from the first entity and \$120 expected from the second client will then both have a present value of \$100. Assigning a precise discount rate to a specific future cash flow is a complex science.