The time value of money dictates that one dollar in hand today is worth more than one dollar to be received in the future, since one dollar now could be invested and the holder can earn interest to generate more than a dollar in the future (Brigham & Houston, 2019). If we invest $10,000 today with an interest rate of 5%, then we will get $10,500 a year later ($10,000*(1+0.05)). This simple case pointed out that $10,000 today is worth more than $10,000 in the future.
If we reinvest the $10,500 with a 5% interest rate, we will get a higher amount of money in the next years to come. The interest will be earned on top of other interests before that, and this is called compounding (Whitecotton et al., 2020). Given the present value of $10,000, the compounded future value can be calculated at a given interest rate.
In capital budgeting, analysts usually forecast future cash flows for years to come. In some cases, the future value can be forecasted, but we have to analyze what it is worth in the present day. Instead of calculating the compounded future value from a given present value, we need to calculate the present value of future cash flows.
If we forecast that we will receive $10,500 next year with an interest rate of 5%, we should know that the sum of money is worth $10,000 today, using the reverse method of compounding calculation, called discounting (Whitecotton et al., 2020). This is the main idea of discounted cash flow, where forecasted future cash flows are stated as present values.
The discounted cash flow is usually used in the net present value (NPV) analysis of a project. The NPV analysis compares the present value of a project’s cash inflows to the present value of its cash outflows (Garrison et al., 2018). All of the forecasted future cash flows (in and out) are converted to present values, and then we take the sum of those values.
Generally, if a project has a positive NPV, the project is forecasted to generate sufficient cash flows to cover the cost of capital and create economic value for its shareholders (Whitecotton et al., 2020). On the contrary, if a project has a negative NPV, the project is expected to have insufficient cash flows to cover the cost of capital and the recommendation would be to stop the project.
While this method has limitations, it is still one of the most common techniques to analyze whether a project is worth to be pursued or not. This method incorporates the fundamental concept of time value of money. It also provide the value of a project, which will be very helpful in a comparative analysis.
References Brigham, E. F., & Houston, J. F. (2019). Fundamentals of Financial Management (15th ed.). Cengage Learning. Garrison, R., Noreen, E., & Brewer, P. (2017). Managerial Accounting (16th ed.). McGraw-Hill Education. Whitecotton, S., Libby, R., & Phillips, F. (2020). Managerial Accounting (4th ed.). McGraw-Hill Education.