Net Present Value
Warren Buffet famously proposed the analogy of a machine that produces one dollar per year in perpetuity. He asks how much would you pay for this machine? Clearly it is worth something more than $1.00. And it’s equally clear that it’s not worth $1,000. The value is somewhere in between. But where?
This leads to the concept of discount (which we mentioned in Falling Productivity of Debt two weeks ago). A dollar to be paid next year is worth less than a dollar in the hand today. One reason is that we are mortal beings.
In order to be alive next year, we must remain alive every single day between now and then. There are natural reasons for time preference – the desire to have a good today, and not postpone it. We are also not omniscient. Something may come up, such as an illness, which forces us to consume what we did not plan to consume.
Another reason is, of course, risk. Unlike the magic machine in our example, a business enterprise may cease to make money for any number reasons including a new competitor or changing customer preferences.
For many reasons, a dollar to be paid next year is not worth a dollar today. A dollar to be paid in ten years is worth even less. Future payments must be discounted. The discount is related to the interest rate, and it shares many of the same causes.
This post was published at Acting-Man on November 2, 2017.