The following topic will be addressed in this post:
How do managers use the concepts of Present Value and Future Values?
Managers of firms study many concepts and must make many decisions based upon their academic knowledge and their business experiences. Among the most important decisions are investment strategies. Should the firm purchase a new piece of equipment? Should a firm expand a line of business or enter new lines? Decisions like these materially affect the firm. Sometimes, these decisions require forecasting decades into the future.
How can managers make these decisions with confidence?
If managers can predict that money spent today will create an acceptable rate of return, sometimes referred to as Return on Investment (ROI), then they should make the investment. To assist these decisions, managers rely on concepts such as Present Value or Future Values of money. At their essence, these concepts are calculations based upon compound interest formulae. Albert Einstein has been anecdotally noted to have said something about compound interest being the world’s most powerful force. While Dr. Einstein may be misattributed, no one doubts that compound interest and the related concepts flowing from it have shaped the current business environment.
To calculate the result of compound interest for some future date, one requires a value for the initial principal, an interest rate (expressed as a decimal), and a time period (usually in years). The general formula is:
Future Value=Initial Principal*(1+interest rate)exponent: time period
On the other hand, if one has the Future Value, interest rate, and time period, and one wants to calculate the Present Value of those funds, called discounting, simply plug in the numbers and solve for Initial Principal. From this general formula, more complex formulae can be developed to calculate results for annuities, variable interest rates, and the like.
All business decisions involve some element of risk, and often the interest rate is called the risk rate. So, the basic theorem states that an investment should be made if the rate of return equals or exceeds the risk rate. Another way to understand this process is through the concept of opportunity costs. The simplest example of evaluating opportunity costs is the decision between keeping cash versus making an investment with that cash. If a manager foregoes a profitable investment for the safety of holding cash then the firm experiences a loss of opportunity, or an opportunity cost.
Among the most powerful applications of these concepts are when a manager has multiple options for investment. The manager must evaluate the ramifications of those options and choose the option or options that achieve optimal results for firm stakeholders. The manager can use the Present Value or Future Value formulae to make side-by-side comparisons of the options.
After evaluating options and choosing a path, the manager must execute the strategy effectively to realize the computed returns. And that is the subject of an entirely different post…
For people seeking more information, Samuel Weaver and J. Fred Preston in Finance and Accounting for Non-Financial Managers provide a fine explanation of the concepts discussed in this post.