The Time Value of Money

"A bird in hand (today) is worth two in the bush (tomorrow)."

Everyone would rather have a dollar in his or her pocket today than to receive a dollar far into the future.  Today's dollar is worth more - that it has more value - than a dollar received tomorrow.

The three main reasons for this difference in value are:

1.  Inflation.
Inflation does reduce purchasing power (value) over time.  With a 5% per year inflation, a dollar received a year from today will only buy 95c worth of goods.

2.  Risk
There is always the chance that the promise of a dollar in the future will not be met and you will be out of luck.  The risk could be low with a CD at an FDIC insured bank; or the risk could be high if it is your brother-in-law who is promising to repay a personal loan.

3.  Opportunity Cost.
If you loan your dollar to someone else, you have lost the opportunity to use it yourself.  That opportunity has a value to you today that makes today's dollar worth more than tomorrow's.

These three concepts - inflation, risk, and opportunity cost - are the drivers of present value (PV) and future value (FV) calculations used in capital budgeting and investing.

Present value (PV) calculations are used in business to compare cash flows (cash spent and received) at different times in the future.  Converting cash flows into present values puts these different investments and returns onto a common basis and makes capital budgeting analysis more meaningful and useful in decision-making.

Nominal dollars are just the actual amount spent in dollars taken out of your wallet.  Real dollars are adjusted for inflation.  When you take out inflation (i.e. convert from 'nominal dollars' into 'real dollars') the price difference becomes much more comparable and easy to explain.

Capital Budgeting

In capital budgeting, different projects require different investment and will have different returns over time.  In order to compare projects "apples to apples" and "oranges to oranges" on a financial basis, we will need to convert their cash flows into a common and comparable form.  That common form is present value.

Simply put, a little bit of cash that is invested today followed by lots of cash returned in the near future would be a REALLY GOOD financial investment.  

However, lots of cash invested today followed by a little bit of cash returned in a long time would be a REALLY  BAD investment.

Capital budgeting analysis is as simple as that.