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.
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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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.
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.
When shareholders invest money in a business, they, too, use the present value of their expected future payoff to determine if the firm is worthy of their funds. If you have $10,000, and buying shares in a risky firm is expected to grow your money to $12,000 in a year, you must calculate the present value of the future payoff to make a decision. If an appropriate discount rate is 15 percent, given the risk involved, the present value of the expected payoff is $12,000 /(1+15%) = $10,435. This makes the investment worthwhile, since buying stock in this firm with $10,000 is equivalent to having $10,435 at hand right now -- a profitable proposition. Since stockholders will evaluate the prospects of the firm as a whole using the concept of future value, the firm also must evaluate each project with the same mindset.