Copyright © 2008, The McGraw-Hill Companies, Inc.
14.1 The Present Value Method 565Making Financial Projections
Mathematical calculations are only as good as the assumptions on which they are based.
Overly optimistic assumptions lead to overly optimistic conclusions, overly cautious
assumptions lead to overly cautious conclusions, and overly pessimistic assumptions lead
us to abandon all hope. The first step in evaluating a business venture is to understand it.
No matter how good your mathematical calculations, you can’t expect to properly evaluate
the prospects of a dairy farm if you don’t know a cow from a bull.
Assuming you understand the nature of the business venture you are contemplating, you
next need to carefully investigate the prospects for the particular venture itself. The 1990s
saw an enormous boom in Internet technology, and vast fortunes were made by visionary
business people who saw that potential and seized on it. Nonetheless, there were plenty
of failed Internet businesses, even in the midst of this tremendous boom. Businesses with
great products or brilliant minds behind them or great business plans lost out to companies
with greater products or more brilliant minds or greater business plans.
Finally, it is important to recognize that any projections that you make must inevitably
be guesses. Very well educated guesses, hopefully, but guesses nonetheless. It is easy to fall
into the trap of having worked through a very solid and well-researched financial projec-
tion and then forget that the numbers are predictions. There is always a risk that things will
not work out according to plan. The future is more likely to match a well-founded predic-
tion than a bald-faced guess, but we must always be careful to remember that nothing in
this life is really guaranteed.Present Values and Financial Projections
Any type of investment will require some patience to pay off. You may invest in a busi-
ness opportunity hoping to earn a good return on your investment, but that return will not
be immediate. Profits made will be spread out over time in the future. Given the choice
between two possible investments, then, you cannot simply add up the amount you expect
to earn from each and see which is bigger. Time is a factor. An investment that will pay you
back $10,000 each year over the next 3 years is almost certainly preferable to an investment
that will pay back $40,000 in one lump sum 20 years from now. It’s not worth having to wait
an extra 17 years before you get any return on your investment in order to be able to get a bit
larger return when it finally arrives. The time value of money is an important factor here.
Mathematically, we can compare investments by considering their present values. Present
values allow us to directly compare the two, apples to apples, by comparing their worth to
us in today’s dollars. What interest rate should we use to determine the present value? That
depends on what rate of return we expect from our investments. Suppose that we can safely
earn a 5% rate of return from other investment opportunities. Then we would certainly be
interested in either investment only if we would earn a higher return—otherwise, why take on
the bother or risk? How much higher is a matter of choice, depending on how much risk the
investment entails, among other factors. For purposes of this example, let’s suppose that we
would require a 7% rate of return, and so we will use that to evaluate these investments.
The investment that pays $10,000 annually for 3 years would then be worth:PV PMTa n (^) | (^) i
PV $10,000a 3 | (^) .07
PV $10,000(2.6243160)
PV $26,243
On the other hand, the investment that pays $40,000 all at once in 20 years would be worth:
FV PV(1 i)n
$40,000 PV(1.07)^20
$40,000 PV(3.8696844)
PV $10,337