The present value rule -- the future is less valuable than the present. To make decisions now -- really the only kind we make -- it is useful to know the "present value" of future money. Present value is the current dollar value of a future amount -- what would have to be invested today (at a given interest rate over a specified period) to equal the future amount. What is a dollar in the future worth? It depends on when it will be received and our current investment opportunities.

Why is a dollar today worth more than a dollar tomorrow?

• We prefer present consumption to future consumption. People can be induced to delay consumption, but only by offering them more in the future.
• There is always some uncertainty (risk) regarding future cash flow. Will the dollar be paid when promised? Will the debtor be willing or able to pay the full amount? Complete assurance is impossible.
• The value of currency fluctuates. When there is monetary inflation (which is generally the case over the long term), the value of future payments declines.

As we will see throughout this course, these three factors play a role in virtually all valuation decisions.

Discounting - a method for determining present value. To arrive at a present value of future money, we need a method that accounts for why current dollars are worth more than future dollars. The mechanism for capturing these elements is the discount rate—the rate at which future cash flows are discounted back to today’s dollars. The discount rate varies in a common-sense fashion:

• If receiving cash flows now is important, the higher the discount rate.
• If the risk of not receiving future cash flows is high, the higher the discount rate.
• If inflation is expected to rise, the higher the discount rate.

A discount rate vastly simplifies the valuation process—incorporating each of these three elements (current consumption preference, risk, and inflation) into a single, easily-applied metric.

For example, imagine you are a venture capitalist. Entrepreneurs pitch business plans to you all day, desperate for your investment dollars. Each of the possible projects is very different: They have different time horizons—some predict it will be only one or two years before an expected return on investment, others five or more years.They all carry varying degrees of risk—perhaps some are in established industries and markets, while others look to delve into emerging areas. There may even be different inflationary environments to consider if you are working in international markets.

How do you even begin to undertake what seems like an “apples and oranges” comparison? The answer is in the discounted cash flow methodology. By applying a discount rate appropriate to each potential investment, we bring these disparate opportunities down to a single, comparable value. After applying the DCF methods, we have a sense of what the value of each of the projects is to you, the investor, in present day dollars, not future projections and promises. Once cash flows are brought to the same point in time and assigned a present value, meaningful comparisons and aggregations can be made.

Who decides what discount rate to apply?How do they decide? There are no firm answers to these questions. These decisions rest on the grounds of professional judgment. Suffice it to say, this is where accountants, valuators, managers, and lawyers really earn their paychecks.

We begin by first learning the fundamental mechanics of present valuation.