Present Value and Decision Making
The present value of money is the value of the money as at the date it is in one’s possession. Usually, the present value of money is compared to its future value to evaluate the viability of certain projects if done in the present or in the future. Drawing an understanding of the time value that money holds helps an individual or an organization identify any misconceptions attributable to real costs. It also helps in the determination of the benefits that projects can accrue and the best courses of action.
The items present value, future value, and discount rates are used in the determination of the net present value. The net present value of money is one of the many components of Cost Benefit Analysis. It is also a useful criterion in government decision making to determine whether their programs can get justification based on the principles of economics. The benefits and costs attributable to money that occur in the future, converted into their equivalent values today, make up the net present value. Since it is usually determined in monetary terms, a program with a positive net present value is usually a cost effective one and one that has a negative net present value, not cost effective (Bierman & Smidt, 2003).
The understanding of the concepts of the present and future values of money is necessary especially to local financial officials and financial decision makers. This is because more informed decisions about projects and programs can be made, based on the data that is collected and analyzed by the financial consultants or staff. The ability to perform the calculations is not seen as an importance of acquiring this knowledge. Decision-making in finance is not an easy process. This is so especially when long periods and large amounts of money are involved. Finding common reference points for different alternatives proves to be one of the most complicated tasks in financial decision-making. Decisions of leasing or buying are also hard decisions that face the managers dealing with financial programs. Net present value acts as a tool that enables managers to make decisions involving the placing of several alternatives into a common period of reference.
The government has proposed two projects X and Y. Both projects have the same aim, to fund the building of an early child development school in a suburb. A project manager in charge of the two projects is handed the task of determining, which between the two projects the government should fund due to its viability and revenue generation capabilities. Project X has a potential of producing $10,000 in the year 2011. In the year 2012, another project Y has the potential of producing revenue of $10,400. Project X and Project Y cannot be compared since they represent different years and no discounting has been done. The value of project X represents a present value while the value of project Y represents future value. For the two projects to be compared, the value of project Y has to be discounted using the correct rate. This brings the two figures to a common level for comparison (Bierman & Smidt, 2003).
Commonly, government projects use 4.5% interest on United States treasury bonds as the discount rate. The present value of project B is determined by using the formula; future value divided by one plus the discount rate and then raised to the power of the number of years. Therefore,
$10,000 / (1+0.045) ^1=9569.38
The present value of project Y is $9,569, and the present value of project X is $10,000. Therefore, Project X is better and more viable for the government to perform since it has a higher value than project Y. This is because the revenue of project Y is in the future and due to inflationary forces, the value of the money then shall have reduced compared to the value of the same amount of money in the present.
Bierman, H., & Smidt, S. (2003). Financial Management for Decision Making. New York, NY: Beard Books.