The present value of future dollars is called the Net Present Value (NPV), and it involves the economic principle of Opportunity Cost. The opportunity cost is the next best use for your money instead of your current purchase, or it can be the next best use of your time instead of what you are using it for now. For example, the opportunity cost of paying college tuition could be giving up on buying a new car. The opportunity cost of going to class could be getting a few more hours of sleep. The opportunity cost of not having a specific amount of money this year instead of next year is the interest or dividend you earn through investment.
This concept is important in business because the principal way a business can value an investment is the stream of income the investment throws off, discounted to the present. This is called Net Present Value of Discounted Cash Flow.
What interest rate (or discount rate)should you use to discount future streams of income? As a student, your opportunity cost would most likely be the 2% interest you would earn in a savings account. For business, the discount rate used is most often 8% or 10% per year because this is the return they would get by investing in their business if they had it now instead of later.
If a company buys an investment that generates $100,000 per year for ten years. The discounted cash flow or net present value of this cash flow stream is:
- Amount Per Year: $100,000.00
- Discount Rate: 8%
- Time Period: 10 years
- Discounted Cash Flow: $724,688.78
The mathematical formula for Net Present value is:
Note that we are dividing the cash flow or income from each period by 1 plus the discount rate, so this is reducing the cash flow by the discount rate. There are many online calculators that you can use to calculate the Net Present Value of future cash flows.