FIN101 #17 FIXATED ON THE FUTURE

Oct 7, 2021 FINANCE 101

­Finance professionals look to the future for the most important questions regarding the value implications of any decision. In short, the source of all value today is future performance as manifested in cash-flows.

Would you be indifferent to a dollar received today and a dollar received in ten years? Clearly, no. So, ­finance prescribes thinking about the free cash-flows an asset will generate in the future and figuring out what they are worth now.

This core idea in ­finance is something really simple: $1 today is worth more than $1 a year from now.

Why? Well, if you have $1 today, you can do something with it and earn a return—which means that you’ll end up with more than $1 a year from now. That simple insight also means that $1 received a year from now must be worth less than $1 received today. But how much less?

That differential depends on the opportunity cost of that money. What opportunity for earning a return are you giving up? What could you have done with the money if you didn’t have to wait? Once you ­figure out the cost of waiting, you then “punish” that future cash-flow by assessing a penalty that accounts for that opportunity cost. That’s called a discount rate. The idea of punishing cash-flows may seem odd, but that’s literally what you’re doing in discounting-you’re punishing people who make you wait to receive your money because you don’t like to wait and because you could have done something with that money if they hadn’t made you wait.

Discounting

How can we operationalize the idea of the time value of money and the notion of opportunity cost? One simple way is by using the notion of an interest rate. Let’s say that if you put money in the bank today, you’ll earn 10 percent, and then one year from now, you’ll end up with $1.10. Fundamentally, that makes you indifferent between $1 today and $1.10 a year from now. That’s the fi­rst clue why $1 today is worth more than $1 a year from now.

Discounting Formula: Cash flow (CF)/(1+r)      where r = discount rate

For example, say you want to ­figure out how much $1,000 received one year from now is worth today. Assume that a bank offers you an interest rate of 5 percent, and that is the relevant alternative investment you would have made if you had that money now. You can use the method described to calculate that a $1,000 payment received one year in the future has a present value of $952.38 using that 5 percent. If you give the bank $952.38 today, it will give you $1,000 next year.

By thanhnambui

I am a bank employee specializing in trade finance- a field that is not directly linked to my university major in Financial Investment. However, with a passion for economics and finance, I determined to pursue a higher education degree and successfully achieved a Master in Economics of Banking and Finance from CFVG in 2019. During that study time, I encountered many difficulties in consolidating background knowledge studied at university, which made me realize the necessity of building foundation for effective learning outcomes. Therefore, my friend and I decided to create Econfin-Invest to record basic knowledge of economics, banking, finance, and investment fields. The articles I write are carefully selected and collected from a wide range of different reliable sources such as textbooks, economic and financial reports and relevant journals. Most importantly, these articles are not A to Z lectures of subjects related to the aforementioned fields, yet simply articles I consider to be accessible to all interested readers as well as being essential to apply in everyday practices. Thank you for reading and supporting!

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