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Related Topics of Present Value, Cash Flow and Risk

Despite the several methods already described for analyzing the profitability of an alternative (i.e., enterprise analysis and partial budget analysis), there are several other points for a manager to consider.

1.  Many investments generate income beyond the first year.  That is good, but this also adds some complexity to the analysis because a dollar received in the future has less value than a dollar received today.  Therefore, when analyzing the profitability of an investment that will be paid for with income received in future years, the value of that future income needs to be discounted to determine whether there is enough income to justify the expenditure/investment at this time.

• The concept of time value of money is introduced below.

2.  An investment generally demands cash and if a loan is borrowed to make the investment, the loan needs to be repaid in the future.  As described on other pages, a cash investment is NOT a cost on an income statement and principal payments on a loan are NOT a cost. Thus analyzing only the profitability of an investment does not reveal whether the business will have enough cash to make the investment, even if it is a profitable investment.

• Review cost v. cash outflow.

3.  An investment involves risk and without an explicit assessment of risk, the manager may overlook uncertainty if only profit is considered and not the potential fluctuation in revenue, cost and profit.

• Risk analysis is addressed at ???
• Risk Analysis in Investment Appraisal by Savvakis C. Savvides. Published in “Project Appraisal”, Volume 9 Number 1, pages 3-18, March 1994.

Each of these concepts needs to be considered as a manager analyzes an alternative.  Focusing solely on profit is not adequate.

Time Value of Money

What if the impact of a decision extends over a longer period, such as several years?

• Does this question require preparing an enterprise analysis or partial budget for each year?
• How do trends in the industry impact the analysis?
• How does the concept of "Time Value of Money" impact the analysis?

• Thoughts on how to identify the discount rate.
  • Question 1 -- what risk is associated with the future payments? That answer suggests an appropriate nominal interest rate.
    • Example:  If the project is relatively risky, it would warrant a higher nominal interest rate than a less risky project.
  • Question 2 -- will inflation impact the future payments?
    • If no, use a nominal discount rate.
    • If yes, proceed to question 3.
  • Question 3 -- will the projected future payments be adjusted in the analysis to reflect the expected impact of inflation?
    • Example:  the project is expected to return $50 each period. If the analysis holds the amount at $50 for each period, the future payments are NOT being adjusted in the analysis and the answer to the question is "no". If the return in the analysis is $50 for the first period, $53 for the second period and $56 for the third period solely due to expected inflation, the answer is "yes".
    • If yes, use a nominal discount rate.
    • If no, proceed to question 4.
  • Question 4 -- is the inflation rate for the return on the project equal to the expected general rate of inflation?
    • If yes, use a real discount rate; that is, the nominal rate minus the general rate of inflation.
    • If no, adjust the real discount rate (nominal interest rate minus expected general rate of inflation) to reflect the difference between the expected inflation rate for the project and the expected general rate of inflation. For example, if the rate of inflation for the return on the project exceeds the expected general rate of inflation, the real discount rate needs to be adjusted downward.

• To conduct this analysis, the manager needs to understand the risks associated with the project, and how inflation may impact the future payments of the project.
• The manager needs to understand 1) the difference among several nominal rates of interest (usually a risk factor) and 2) the difference between a nominal rate of interest and a real rate of interest (the difference is usually the rate of inflation).

• This analysis fits into the discussion of the decision making process, for example, the steps of a decision making process may be a) identify problem to be addressed, b) identify alternatives, c) gather information, d) analyze information, e) make the decision, f) implement the decision, and g) monitor results of decision. A "time value of money" analysis is a component of the "analyze information" step in the decision making process.

Integrated Analysis

Description of Integrated Analysis for Decision Making... provides an overview of how time value of money, cash flow, and risk can be incorporated into an enterprise or partial budget analysis.

Last Updated November 6, 2010

Email: David.Saxowsky@ndsu.edu

This material is intended for educational purposes only. It is not a substitute for competent professional advice. Seek appropriate advice for answers to your specific questions.

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