April 3, 2017
CURRENT VALUE OF MONEY
Because of inflation, interest and investment returns, the money a company possesses today has the potential of being worth more than money it receives in the future. Therefore, enticing debtors to pay quicker is advantageous for companies.
A business must consider the value of money on hand with the relative value of money it will receive or pay out in the future. Factors that influence these decisions are Inflation, risk, potential investment returns, loan interest and average customer repayment period. If the business sells products and services on credit, it must consider the lost opportunity to earn interest on the money if the customer paid cash up front.
Some companies provide discounts for paying sooner, e.g. 3/15, NET 30 DAYS, where a customer may deduct 3%, if they pay within the first 15 days. Otherwise, the entire amount is due in 30 days.
When a business decides to purchase an item or invest in something, it may take years before that cash outflow produces a positive return on investment. When comparing the future value of money, the decision maker must know if the profit will exceed the expenditure.
FUTURE VALUE OF MONEY
To do this, decision makers apply a discount rate to determine the future value of a dollar.
They add the positive and negative cash flows of a project or investment. Then, they convert those amounts into present day values.
If the present value of the cash flows are less than a project or investment value, it is not worth the outflow of cash. If it is greater than the outflow of cash, it is worth approving.
VARIOUS DECISION METHODS
There are several ways to calculate a return on an investment.
One method is by using net present value, i.e. add present cash flows to determine a value of greater than zero for approval or less than zero for a determination of disapproval.
Another method is the internal rate of return, i.e. use the cost of the project and rate of return. Use the present value of future cash flows to determine if it equals the upfront cost. If it is greater than the discount rate, the project or investment is worth the initial cost.
Understanding the return on investments and expenditures helps decision makers decide between competing priorities, projects, investments and purchases. It will help determine where to place a company’s cash that will do the greatest good, in terms of return on initial cash outflow.
Financial management is the responsibility of all managers. Effective and efficient utilization of funds is one way of decreasing costs, selecting the most profitable projects and insuring actions that benefit the company the most get the greatest attention.