MANAGERIAL ECONOMICS AND BUSINESS STRATEGY

MICHAEL R. BAYE

Recognize the Time Value of Money

The timing of many decisions involves a gap between the time when the costs of a
project are borne and the time when the benefits of the project are received. In
these instances it is important to recognize that $1 today is worth more than $1
received in the future. The reason is simple: The opportunity cost of receiving the
$1 in the future is the forgone interest that could be earned were $1 received today.

This opportunity cost reflects the time value of money. To properly account for the

timing of receipts and expenditures, the manager must understand present value
analysis.

Present Value Analysis

The present value (PV) of an amount received in the future is the amount that would

have to be invested today at the prevailing interest rate to generate the given future
value. For example, suppose someone offered you $1.10 one year from today. What
is the value today (the present value) of $1.10 to be received one year from today?
Notice that if you could invest $1.00 today at a guaranteed interest rate of 10 per

cent, one year from now $1.00 would be worth $1.00 1.1 $1.10. In other

words, over the course of one year, your $1.00 would earn $.10 in interest. Thus,
when the interest rate is 10 percent, the present value of receiving $1.10 one year in
the future is $1.00

The basic idea of the present value of a future amount can be extended to a
series of future payments

Given the present value of the income stream that arises from a project, one can
easily compute the net present value of the project. The net present value (NPV) of
a project is simply the present value (PV) of the income stream generated by the
project minus the current cost (C0) of the project: NPV PV C0. If the net pres
ent value of a project is positive, then the project is profitable because the present
value of the earnings from the project exceeds the current cost of the project. On the
other hand, a manager should reject a project that has a negative net present value,
since the cost of such a project exceeds the present value of the income stream that
project generates.