Valuation Principles

Topics: Net present value, Rate of return, Investment Pages: 3 (739 words) Published: December 18, 2008

Because rational people prefer to receive benefits sooner than later and make sacrifices later than sooner, money, which provides the option to buy benefits, is likewise preferred sooner to later.

If an individual prefers money sooner than later, then he/she values a dollar today more than a dollar tomorrow or a dollar in one year from now. A dollar today is worth a dollar today: therefore, a dollar next year must be worth less than a dollar today since it is less preferable/valuable.

In other words, the same amount of money will be more or less valuable depending upon when it is received. What would you prefer, $100 today or $100 in one year from today? Most people prefer $100 today since it gives them the option to spend it today or save it and spend it in one year. Receiving $100 in one year doesn't allow for $100 in consumption today.

For equal amounts of money, the decision when to take money --today or in the future-- is an easy one: sooner is always better than later. But what about situations where the amounts differ? What decision rule should be used in those situations?

For example, what is preferable? $100 today or $133.1 in three years? Simply picking the largest number may not provide the best value. (Another way of viewing this situation is to ask: would you pay $100 today to receive $133.1 in three years?) The answer depends upon what could be earned with the $100 in alternative investments. Suppose that it's possible to earn 5% on the $100. Then after three years it would accrue to $115.76. In that case, it would be better to wait and take the $133.1. If 15% could be earned, the $100 today would grow to $152.08 and the $100 today would be more attractive.

In this example, we compared future values of the alternatives (at the same point in time). Alternatively, we could have looked at present values by asking "what are you willing to pay today for a promise of $133.31 in three years?" As you might infer,...
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