Here is a little Financial Decision-Making review for you…
…Time value of money is taught as the basis for financial decision making in all reputable business schools. Cash is king, meaning earnings are a garbled version of the actual cash firms make. Cash in-flows are present valued and compared to the present value of cash outflows to make a financial decision.
A basic principle that is rarely taught but assumed to be obvious is this:
Never add or subtract “dollars” unless they occur at the same time frame.
This should be obvious, but we make this mistake often.
For example, consider the following scenario: A family is trying to sell a home during a tough economic year. They haven’t had a bite on the house in several months. They want to move to a new home, but it is contingent on selling the first home. Let’s say they are asking $200,000 for the original home.
A real estate broker calls and offers them their asking price. Euphoria breaks out at the seller’s home. When the real estate broker comes over with the papers, the “deal” is this: $100,000 today and $20,000 each year for five years.
“Congratulations,” says the real estate broker, “You got your asking price!”
Or did they?
The present value of that series of cash flows is substantially less than the asking price.
If the homeowner was unaware of the basic rule to not add or subtract money unless they occur at the same time frame, they might have had the wool pulled over their eyes.
The “deal” was really worth about $175,000 assuming a 10% discount rate, not unusual in such economic times.
In business, always “present value” any cash flows to see the true economic value of any deal IF the cash flows don’t occur at the same time.