Ask Mint | Knowing the present value of future cash flows is useful

Ask Mint | Knowing the present value of future cash flows is useful
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First Published: Sun, Aug 31 2008. 11 28 PM IST

Illustration: Malay Karmakar / Mint
Illustration: Malay Karmakar / Mint
Updated: Mon, Sep 01 2008. 12 41 PM IST
Money has no legs of its own and yet it keeps on moving around faster than all of us. This makes money all powerful. But time is a great leveller. What looks like a mountain of money today may become dust tomorrow if money does not keep on moving with time.
Johnny is, however, interested in understanding things in the reverse order. A fortune-teller has predicted that Johnny will have a mountain of money after 30 years. Johnny wants to know the present worth of his future mountain of money. In other words, Johnny wants to know how he can calculate the present value of future money.
Jinny: Hi, Johnny! Why are you standing on your head today?
Johnny: I am trying to understand things in the reverse order. If I have a mountain of money after 30 years, what is its actual worth today?
Jinny: Well, you just need to make smart use of your calculator to know that. If somebody promises to pay you Rs1 crore after 30 years, you may feel that after 30 years you would have a mountain of money. But don’t entertain the notion that after 30 years you could lead the lavish life of a present-day millionaire!
You should always compare the future value of your money with its present value to see its true worth. What is its worth now? For that you need to discount the future value of money to its present value by the expected rate of return on present investments.
Illustration: Malay Karmakar / Mint
Last week I had told how you could know the future value of your present money by compounding it with the expected rate of return.
Discounting is just the opposite of compounding. Financial experts use different mathematical formulas for doing compounding or discounting.
However, if you are not familiar with formulas then doing some reverse thinking may help. You can rephrase your question like this: If Rs1 lakh is worth Rs17.45 lakh after 30 years at a 10% rate of return compounded annually, then how much more should you invest now so that it is worth Rs1 crore at the same rate of return?
You can use financial formulas for doing calculations but if you are allergic towards any kind of formula then a little bit of trial and error on your calculator will tell you that the present value of Rs5.70 lakh would be close to Rs1 crore after 30 years at the same rate of return.
So what’s the conclusion? The Rs1 crore that you would be getting after 30 years is as good as getting Rs5.70 lakh now. That may sound disappointing.
But cheer up! The present value of your future money may not be good enough to let you buy a new house but you can definitely buy a decent car.
Johnny: The mountain of money after 30 years really looks like a mountain of peanuts in terms of its present value!
Jinny: Don’t be so disappointed. You should always keep in mind that the present value of your future money depends upon the length of time and the rate of return you use for discounting. A higher rate of return and longer period of time would lead to a lower present value of the future money.
Conversely, a lower rate of return and shorter period of time would lead to a higher present value of the future money. The length of time you have to choose is obvious but what is the rate of return you should choose for discounting the future money? You have to choose a realistic rate of return that makes some sense.
But the problem is that different investments may yield different rates of return. Some of these investments may be more risky than others. A 30-year bond may yield a rate of return different from a 30-year investment in stocks or real estate.
When there is a possibility of earning different returns on different investments with different risk profiles, choosing the actual rate of return for discounting is a tough job. There is always scope for an error of judgement and the present value may be grossly undervalued or overvalued. Here we have to exercise our good sense. Choose the average rate of return on different investments or the rate of return on the safest investment for the purpose of discounting the future cash flow. Neither be a liberal nor a conservative when it comes to counting your money.
Johnny: How can knowing the present value of future money help us?
Jinny: Knowing the present value of future money can help us in many ways. You can make wiser investment decisions by comparing the amount of money required for investment with the present value of future cash inflows from your investment.
If the present value of the future cash inflows is greater than the value of the present investment, then it means that making investment makes good sense. Otherwise, you may be sacrificing your glorious present for the sake of a darker tomorrow.
Johnny: That’s true, Jinny. Sometimes we may miss the present while chasing the dreams of tomorrow.
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What:The present value of future cash flows can be calculated by using the method of discounting.
Why: Knowing the present value of the future cash flows helps in judging their true worth in terms of the time value of money.
What: The present value of future money depends on the length of time and the rate of return used for discounting.
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Click here to read all of Shailaja and Manoj K. Singh’s earlier columns
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
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First Published: Sun, Aug 31 2008. 11 28 PM IST