Everyone knows that a dollar today is worth more than a dollar a year from now. The reason for this is because of the time value of money. To illustrate the time value of money, let us look at the following equation:
Where FV = Future value of an investment PV = Present value k = Investment interest rate (or cost of capital) n = Number of years
Using this formula, we can see that an investment of $1,000 today (i.e., PV) invested at 10% (i.e., k) for one year (i.e., n) will give us a future value of $1,100. If the investment is for two years, then the future value would be worth $1,210.
Now, let us look at the formula from a different perspective. If an investment yields $1,000 a year from now, then how much is it worth today if the cost of money is 10%? To solve the problem, we must discount future values to the present for comparison purposes. This is referred to as "discounted cash flows."
The previous equation can be written as:
Using the data given:
Therefore, $1,000 a year from now is worth only $909 today. If the interest rate, k, is known to be 10%, then you should not invest more than $909 to get the
$1,000 return a year from now. However, if you could purchase this investment for $875, your interest rate would be more than 10%.
Discounting cash flows to the present for comparison purposes is a viable way to assess the value of an investment. As an example, you have a choice between two investments. Investment A will generate $100,000 two years from now and investment B will generate $110,000 three years from now. If the cost of capital is 15%, which investment is better?
Using the formula for discounted cash flow, we find that:
This implies that a return of $100,000 in two years is worth more to the firm than a $110,000 return three years from now.
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What you need to know about… Project Management Made Easy! Project management consists of more than just a large building project and can encompass small projects as well. No matter what the size of your project, you need to have some sort of project management. How you manage your project has everything to do with its outcome.