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This Wiki page describes the methodology of measuring the value and cost of projects using the de-facto standard methodology used in corporate finance called present value. Sometimes it is referred to as Net Present Value (NPV) to indicate the fact that there are positive and negative value flows on projects.
This methodology is based on an underlying mathematical model called Discounted Cash Flows (DCF). Sometimes DCF is conflated with NPV. NPV is much more. It includes both the mathematical model for discounting value flows over time, as well as the methodology for assessing the risk involved in a project and thus the appropriate discount rate to use, and the criteria for financial-based decisions on whether to pursue a project.
Definition of a Project
What do we consider by a project?
I use the term project in broad terms. It could refer to a corporate project or initiative. It could refer to public policy. It could refer to an investment in a company or stocks. It could literally be buying a car.
A project, in broad terms, is a decision to allocate valuable resources you own in order to derive some benefits from them.
Let’s look at a couple of examples.
Company ACME Inc. decides to start a software development project, to build an app. They will need to invest some money to buy the tools and hire a team, pay the salaries, and a year from now the app will be finished. They will sell the app in the app store and earn the revenue from it until the app becomes outdated or stops selling.
Here is another example of a project. Joe decided to take up a freelance job as an Uber Eats driver. He decided to buy a used car (cheap one) that will help him deliver food faster compared to those guys on electric bikes. He needs to spend money on gas and insurance. He will earn a commission for every delivery he makes.
Here is another example. The city council is debating whether to allocate the budget to repair the potholes in the roads or to build a new homeless shelter. They can’t do both with the projected tax revenue, although if they borrowed and ran a deficit they might. Okay, this project is harder to evaluate but it’s a project nevertheless. And you would be right in thinking that these are actually two different projects – project A is to repair the roads and project B is to build a new homeless shelter. Each can stand on its own and each can be favorable or unfavorable on its own. In a constrained world, with sparse resources, you might be tempted to evaluate one vs. the other. In an unconstrained world, where you are free to borrow to invest in a favorable project, you don’t have such a limitation.
Which brings us to a crucial point in budget allocation. When should the organization borrow money to pursue some project? This topic goes beyond the scope of this section but it supremely important. I’ll get to it later. Short answer is, when the project is favorable but only accounting for the change in the cost of borrowing and it can afford it. There are so many risks and externalities here that people forget and borrow foolishly which gets them in trouble.
Time Value of Money (and Value)
Why does money have a time value? Finance, and frankly all of capitalism, is based on the notion that humans prefer to get value sooner rather than later. That the value earlier is more valuable to a person than the same value amount but at a later time.
Think about it this way. If you ask a kid, would you like ice cream now or in one hour, most of them will say now. Because they like ice cream and they want it right now. On the other hand, if you ask them would you go to bed now or in one hour, they will ask to go to bed in one hour. Because they prefer leisure to sleep time. And sure, a few will inevitably, in particular cases, have a preference to defer benefits but not because they inherently value deferring but because they have an alternative they wish to pursue in the meantime. No rational human would prefer to defer something they like or incur something they dislike, all else being equal.
Another way to think about it in the business context is as follows. If I receive a benefit now, I have the freedom to decide what to do with that benefit. I can sell it and spend the money on something, or I can consume it somehow, or I can sell part of it, invest it in another project, and consume the rest. That freedom to decide what to do with that benefit and the ability to derive more value from it by investing it or more pleasure from it, is itself valuable to me. If I don’t get the benefit until later, I lost that ability and lost the potential profits or pleasure I could heave earned. In finance, this concept is referred to as the opportunity cost of capital.
What does this have to do with valuation? Well, everything. Projects are about allocation of resources, i.e. spend. Doesn’t matter what kind of resources – labor, capital, intellectual property, doesn’t matter – it’s spend. That spend is typically not all upfront but over time, e.g. multiple years. Similarly, projects yield benefits over time. If it was possible to spend a bit of money once and momentarily improve healthcare that would be amazing, but that’s not how the real world works. Value takes time to materialize.
So, the only rational way to evaluate long-term, multi-year, project investments is by applying the present value methodology. Anything else would simply be ignoring the time-value effects, i.e. it would be wishful thinking.
To play devil’s advocate, someone could argue – why don’t we just make one-year decisions, i.e. break up long-term decisions into short-term ones. You can’t and here’s why. Most projects require an upfront investment but the benefits don’t materialize for 1-2 years. It’s called a hockey stick. If you just evaluated the first-year impacts, it will be, in most cases, unfavorable. So, you would miss out on projects that are in reality very favorable, but whose benefits start materializing 1-2 years after the start of the project.
Another common pushback is, well why do we have to discount, let’s just use the total value and total cost. Again, you’re ignoring the time-value aspects. Different projects have a different time dynamic of spend and benefits. Project A may require $100 investment upfront and yield $60 after year 1 and another $60 after year 2, while Project B requires $1,000 upfront and yield $1,020 after year 1. Clearly a different situation - there is a different amount of money at stake, it pays the same profit but earlier etc. – cannot be compared on totals alone.
What would happen if we did just add up without discounting? A couple of things. First, that’s just equivalent to using a discount rate of 0%. Basically, you are saying my opportunity cost of capital is 0% because I have nothing else to do with my money and I acquired it for free. Secondly, you are also saying you don’t care when you receive the benefits (could be 30 years, could be 200 years, could be in 1 million years). Finally, you are also implying that you are 100% certain that the project benefits will materialize, i.e. the project will succeed. Yes, evaluating the probability that the project may not succeed is one the key reasons why we discount the future.
We’ve been using the term money here but money is just an accounting concept to model value. The real-world concept here is value. And the same principle of time-value applies to value – all kinds of value – financial value (e.g. cash or stocks) and non-financial value (e.g. pleasure, quality of life).
Okay, to get very precise about it, discounting the future value or cost means dividing by the factor determined as the compounded discount rate (i.e. interest rate). That’s referred to as writing something “in present terms”. E.g. $100 ten years from now, could be $50 in present terms. Sometimes you’ll hear “in today’s dollars” or “in present dollar terms”. Typically, most calculators use annualized discount rates and annual compounding, for historical reasons, and also humans tend to plan yearly (dates back to agricultural times and seasons). But, obviously, it’s arbitrary, you can use any time period.
In this section, we’ve only looked at the concept of time value and how to calculate the present value of a future cost or benefit. Nothing else. Not how to evaluate the project as a whole, not how to estimate risk, that’s for the other sections.