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ory, be exactly indifferent between the two sums. One initial point to stress is

that to count as â€˜a sum of moneyâ€™ in this context, the money must be imme-

diately available to spend.4

So the concept of value refers to an equivalent amount of money that can

be spent. It needs to be qualified by adding a reference to when the money can

be spent. Hence present value refers to money that can be spent now while

future value is money that cannot be spent until some time in the future.

The term future value only has precise meaning when it is made clear exactly

when in the future the money is available.

The time value of money formula allows us to convert future sums of

money into their equivalent now. We have already introduced a special

name for this. We call it the present value. We have defined the present value

of a future amount of cash as the amount that we would be indifferent to

receiving today compared with the future amount given all of its particular

circumstances.

Using value to take decisions

So if value is the equivalent of cash in hand at a specified time, then present

value is cash in hand now. Now the nice thing about cash in hand now is that

it is very easy to count. Furthermore, if offered two amounts we can say that

we would always prefer the greater amount. Contrast this with two different

values, one corresponding to one year ahead and the other two years ahead.

How could we decide between these? It would not be right simply to compare

the two amounts and select the larger. The value approach is to convert each

future value into its present value and then compare these. So when we are

Cash is only really of use if you have it available to spend. If you want to test this statement out, try

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telling a bus driver who asks you to pay the fare that you have the cash but it is at home. This simple

scenario will, hopefully, illustrate the difference between owning money and having money imme-

diately available to spend. The value calculation only takes account of money when it is available to

spend.

8 The five financial building blocks

faced with two possible alternatives, if we were to express both in terms of

their present value we would have a very simple way to make decisions:

Always select the option with the highest present value.

It is important to note the reference to using present value when making

decisions. Would it be correct to make decisions based on maximising value

at some point in the future? For example, what about a decision rule that

required one to select the option with the highest value at the end of the cur-

rent year? What do you think?

Well, the general answer is that such a decision rule would not be a good

one although there is a special circumstance when the answer could be that it

was.5 There are two reasons for future values not being a safe basis for decision

taking. First, there may be different cash flows between now and the point in

time being considered and second, the time value of money may be different.

The point about different cash flows is fairly obvious. Suppose you are

choosing between two options that offer either $150 or $100 at the end of this

year. Your first thought will be that $150 is better. But suppose this option

requires you to spend $50 now in order to gain the right to the $150 later

while the $100 option requires no initial investment. In this situation the

$100 option would clearly be preferable. The discount rate point is also quite

simple. If the $150 was very risky compared with the $100 we might associate a

higher value today to the low risk $100. Note, however, that when the clock has

moved forward to the end of the year, we should take decisions based on what

would then be the present value but today we take decisions based on value

today, i.e. present value.

Taking stock and defining some terms

We have seen how money now is preferable to money later. We have associ-

ated the term time value of money with the concept of an amount of money

receivable in the future such that we are indifferent between it and the alter-

native amount of money now. We have introduced the term value to empha-

sise the difference between money owned and money that is available to

spend. Finally, we have seen how present value can be used as a financial

decision making tool and we understand the distinction between this and

any future value.

This special situation is where the options being considered have the same time value of money and

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the same net cash flow between the present and the point in time in the future where you are assessing

value. In this situation one could adopt a rule of maximising a future value.

9 Building block 1: Economic value

I will give this approach a name and call it the economic value model. The

economic value model gives a means of calculating the present value of any

option or situation.

The following picture shows how it works.

Cash Flow

Present Value

Discount Rate

Fig. 1.1 The economic value model

There are a few more bits of jargon to learn:

â€¢ The process of adjusting a future cash flow to its present value equivalent is

called discounting or discounted cash flow analysis. The abbreviation DCF

is also used.

â€¢ The time value of money can also be called the discount rate or the cost of

capital.6

One important aspect of the economic value model concerns the way that it

treats the cost of any money that is used. This is allowed for via the discount

rate and so any finance charges such as interest are not deducted from cash

flow since to do so would serve to double count them. The basic principle is

that one considers the cash flows which are required or generated before any

finance charges are allowed for. We will return to this point later in the book.

The power of present value lies in two things first: in its intuitive and com-

putational simplicity and second in how it provides a link between decision

taking and how companies are valued. We will deal with both of these points

later in this book. At this stage all we need to know is that values are things

that can meaningfully be added up and that it is generally accepted that the

market price of an asset is set by its value calculated via the economic value

model.

The term discount rate is obviously related to the concept of discounting. The reason for using the

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term cost of capital is not obvious at this stage in the book. For the present, please just accept it as all

will be explained later.

10 The five financial building blocks

For the remainder of this chapter we will concentrate on using the model

to make simple financial decisions.

Part 2: Calculating present values

Now that we have some basic theory in place we can move to the more prac-

tical topic of calculating value. The following sections will introduce some

simple approaches to calculating net present value.

Given the importance of present value it makes sense to rearrange the time

value of money formula so that present value is the subject. Hence:

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