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Financial Management Series Number 3

Explore how to evaluate the value of money over time using Net Present Value in financial management and fiscal policy. Learn about calculating NPV, discount rates, and making cost-effective decisions.

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Financial Management Series Number 3

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  1. Financial Management Series Number 3 Using Net Present Value To Evaluate The Value of Money Over Time Alan Probst Local Government Specialist Local Government Center UW-Extension

  2. Financial Management Fiscal Policy Sound financial decision-making results from an informed fiscal policy and a solid understanding of the value of money and the vehicles through which it is managed.

  3. Financial Management Financial Decisions require consideration of: • Projected revenues over the period of time being considered • Projected operating expenditures over the period being considered

  4. Financial Management (cont.) • The governmental body’s ability to acquire financing, now and in the future • Present and future value of money when applied to the project being considered.

  5. Financial Decision-Making When making financial decisions for a governmental body, the same rational doesn’t necessarily apply as is used in managing one’s own personal finances. What looks like a “common sense” good idea at first may turn out to be a bad financial decision when worked through the formulas

  6. Financial Decision-Making • Performing a Cost/Benefit Analysis is essential to sound financial decision-making • A critical part of a Cost Benefit Analysis is determining the value of money over time

  7. Time Value of Money • Money’s value changes over time • A dollar today is worth more than a dollar tomorrow • When time value is considered, the cost-effectiveness of a project can change

  8. Today’s dollar is worth more because: • Interest rates $100 you invest at a 4% interest rate today will be worth $104 in 1 year, thus making today’s money worth more • Inflation You purchase 20 items today at $1.00 each for $20.00 After one year, due to inflation, those same items cost $1.50 each and you can only purchase 13.33 of that same item with our $20.00. Thus, today’s money is worth more.

  9. Value of Money Over Time Future Value Measures what today’s money would be worth at a specified time in the future assuming a certain discount rate Present Value Measures what money at a specified period of time in the future would be worth if valued in terms of today’s money

  10. Discount Rate • The rate used in calculating the present value of expected yearly benefits and costs • Used to reflect the time value of money • The higher the discount rate, the lower the present value of future cash flows

  11. Real vs Nominal Discount Rates • A nominal discount rate that reflects expected inflation should be used to discount nominal benefits and costs • Market interest rates are nominal interest rates

  12. Real vs. Nominal • A real discount rate adjusted to eliminate the effect of expected inflations should be used to discount constant-dollar or real benefit benefits and costs • A real discount rate can be approximated by subtracting expected inflation from a nominal interest rate

  13. Real Discount Rate (1+ Nominal Interest Rate) = (1 + Real Interest Rate) * (1 + Inflation rate)

  14. Free Cash Flows Free Cash Flowis a measure of cash flow remaining after all expenditures required to maintain the operation

  15. Future VS Present Value • Future Value = Present Value X (1+discount rate) raised to a power of the number of years • Present Value= Future Value/ (1+discount rate) raised to a power of the number of years

  16. Example Future value of 100 of today’s dollars in five years. 100 X (1.0 + .04)5 = 121.67 where .04 is the discount rate.

  17. Done on Excel: =SUM(100*(1+0.04)^5)

  18. Example Present Value of 100 dollars five years in the future. 100 / (1.0 + .04)5 = $82.19

  19. On Excel: =SUM(100/(1+0.04)^5)

  20. Would you rather pay $15,000 now for a year’s worth of your newborn’s education or $30,000 eighteen years from now?

  21. Present value of $30,000 eighteen years into the future + 30000 divided by (1+.04)18 = $14,809

  22. So why is this important? Understanding the time value of money can help you identify misconceptions about real costs and benefits of projects or courses of action

  23. So why is this important? • Future value, present value, and discount rates are used to determine Net Present Value • Net Present Value is a component of Cost Benefit Analysis • Net Present Value is a criterion for deciding whether a government program can be justified on economic principles.

  24. Net Present Value (NPV) • NPV is the future stream of benefits and costs converted into equivalent values today • Programs with a positive NPV are generally cost effective • Programs with negative NPV are generally not cost effective

  25. CalculatingNPV • Assign monetary values to benefits and costs • Discount future benefits and costs using an appropriate discount rate • Subtract the sum total of discounted costs from the sum total of discounted benefits

  26. Project Example • Project A produces $5,000 of revenue in 2006 • Project B produces $5,200 of revenue in 2007 • Which is the more fiscally sound project?

  27. Project Example • You cannot directly compare two different years without discounting • 2006 is Present Value • 2007 is Future Value

  28. Project Example • You must find the PRESENT VALUE of Project B in 2006 to compare • Since this is a government project, we’ll use 4.5% interest on a US Treasury Bond as the Discount Rate

  29. Project Example • The PRESENT VALUE of Project B is determined by: $5,200 / (1+ 0.045) = $4,976 NPV = $4,976

  30. Project Example After discounting, the present value of : Project A = $5,000 Project B = $4,976 Choose Project A

  31. Real World Example New County Historical Society & Museum • Construction cost: $10,000,000 • Visitor ticket: $15 • Annual expected visitors 56,700 • Expected growth of visitors 12% (for 10 year horizon) • Annual maintenance costs $10,000 w/7% growth • Annual repair expenses $5,000 w/7% growth • Discount rate 4.85% (10 yr Treasury Bond Rate) • Depreciation $285,714 w/5% growth • Capital Expenditure $300,000 • Inventory, etc. $5,000 w/5% growth

  32. Real World Example For each year of payback of 10 year project: • Projected revenues – annual maintenance and repair expenses = Benefits • Add benefits + depreciation • Subtract capital expenditure for the year and change in working capital to get Free Cash Flows • Free Cash Flows/(1+.0485) to the power of the year number (1-10) for Present Value of Cash Flows (PVCF) • Total of ten year’s PVCF – Cost of Construction = NPV • NPV this project is $249,758; generally cost effective

  33. Real World Example HOWEVER, if you decrease the expected growth rate in paying visitors from 12% to only 5% the entire picture changes With only a 5% expected increase, using the same formula, our NPV result is a negative ($2,698,349), a major loss and commonly viewed as not cost-effective

  34. Summary As local officials and decision-makers, it is only necessary to understand the concepts so you can make informed decisions based on data presented to you by your financial staff or consultants, it is not necessary to be able to perform these calculations

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