Would you rather receive £100 today or £100 in a year’s time? I am hoping that the answer to that question is today. Now consider this – would you rather receive £100 today or £1,000,000 in a year’s time? I am not trying to second guess your personal financial circumstances, but I am guessing that this time you will opt for the latter and take £1m in a year’s time.  What about £100k?  or £1k?  or £200?  Or £105?

As I reduce the amount from £1m there will come a point at which you will change your mind from taking the increased amount in a year’s time and will opt for the £100 now.  In this example, you are demonstrating what is known as your ‘time value of money’.

Your time value of money reflects the increased value that you put on money today, over and above money received at some point in the future. If, in the above example, you had concluded that you were indifferent between £100 today and £110 in a year’s time, then your time value of money would be 10%.

You may have concluded that you could take the £100 today and invest it – turning it into more than £110 in a year’s time (ignore tax for the time being). Alternatively, you might conclude that, due to inflationary expectations, that the purchasing power of £100 will diminish by 10% over the year.

In exactly the same way that you as an individual are demonstrating a time value of money, so businesses are faced with the same dilemma. Every business has to make some form of financial investment – and these investments must ‘make money’ (i.e. they must return more than the original investment).

To ensure that your business case is a compelling one, you need to do more than merely reflect the fact that the income from an investment exceeds the original investment, you need to demonstrate that - when adjusted for the time value of money – the proposed investment still makes a positive return.

In order to do this, the finance or business analysis team will build a ‘discounted cash flow’ (DCF) model of your proposed investment. They will look at the costs involved in a project (both the capital expenditure for plant and machinery as well as the ongoing operational costs) and compare these to the forecast income. This will give them a forecast cash flow for the proposed investment.

They will then discount these future cash flows back and ‘restate’ them in terms of what they are worth today (just as we valued £110 as being ‘worth’ £100 today in the original example). By adding up all of the Discounted Cash Flows (DCFs) associated with a project, the business analysis team are therefore able to calculate the Net Present Value (NPV) of the business case – that is, the present day value of all of the future incomes associated with the project, net of (or less) the future costs. If the NPV is positive (using the company’s discount rate) then the project is more likely to get the green light.

Wall Street, these guys obsess about return on investment - you should too.

An alternative method is to calculate what the Discount Factor must be to return a NPV of nil.  This is known as the ‘Internal Rate of Return’ (IRR) of the project – it is the equivalent of the interest rate that you might earn by investing in the bank.  Thus, if the discount rate of the company is 10% and the project returns a positive NPV then it is more likely to get the go ahead.  This project will return a IRR of greater than 10%.

The discount rate that a business will use to calculate the NPV is known as the Cost of Capital – in effect this is the opportunity cost of not using the funds elsewhere in the business. This cost of capital will reflect the return that investors (both shareholders – who supply equity, and banks – who supply debt) require. Any project that returns a positive NPV (i.e. has a IRR above the required Cost of Capital) is likely to receive the necessary funding. Any profits that are not reinvested can be returned to the shareholders in the form of a dividend.

As stated above, the discount rate is the company’s internal cost of capital – and is a reflection of the return that equity and debt investors require. Equity investors typically require a higher rate of return than debt investors as their investment carries greater risks (they may not receive any income and may not get their investment back, whereas interest on a loan must be paid as must the original loan itself).

As it is impossible to determine whether each £1 of investment comes from a debt or equity investor, companies will usually take a weighted average – hence the term WACC – or Weighted Average Cost of Capital – in effect the average return demanded by each £1 of investment.

Understanding the WACC of your business and being able to work with your business analysis team or finance department to build a NPV for your business case will increase the chances that your proposals will be accepted.