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Accounting for time: to best evaluate and justify long-term expenditures, HR should understand how finance uses the keystone concept of net present value - Strategic HR

HR Magazine, Sept, 2003 by Steve Bates

Time is money. We've all heard the saying, but in the world of finance it's a governing principle.

A dollar today is worth more than a dollar tomorrow, because inflation erodes the buying power of money, and people would rather have things sooner than later. A dollar today is worth less than a dollar as some time in the past; we could have invested the dollar and received a return on it.

CFOs and other financial analysts use this principle to evaluate spending decisions, particularly capital investments. It's at the heart of a key rule used to decide among Competing uses of scarce funds: net present value (NPV).

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NPV can involve elaborate equations and numerous projections and assumptions. It can appear daunting to those not trained in finance. Yet the concept behind the numbers and symbols is one that HR professionals should be familiar with as they attempt to work more closely with finance professionals and to create credible cost/benefit projections that help justify proposed HR programs and budgets (see "Business Partners," p. 44). Finance departments can help HR complete More complex NPV calculations, and gaining comfort with the Concept will help HR partner better with CFOs and understand How they make decisions.

Use of NPV in calculations "gives you a systematic way to balance payments up front with gains later on," says Robert A. Connolly, an associate professor of international finance and economics at the Kenan-Flagler business School of the University of North Carolina at Chapel Hill. Finance departments--perhaps unbeknownst to HR--use NPV projections to compare "apples to oranges" in competing proposals from sales, marketing, production, IT and other departments, he says. The formulas translate dissimilar spending proposals into financial terms are more comparable.

A Simple Example

The changing value of money over time is easily seen in the classic bank savings account.

If someone deposits $100 in a bank paying 10 percent interest per year, after one year the $100 starting amount increases $10 to a total of $110. If the money is left in the account for another year and the interest rate remains at 10 percent, the account increases by more because the entire $110 balance earns the 10 percent increase. The gain of $11 during the second year results in a new balance of $100 + $10 + $11, or $121.

To calculate how big the account would grow afar several years, use the equation:

PV * [(1+r).sup.t] = FV

where PV is the present (or starting) value of the money, r is the interest rate, t is the time in years, and FV is the future value at the end oft years.

In the savings account example, if one wanted to determine how much money the $100 would grow to after four years at the interest rote of 10 percent, PV would be $100, 1+r would be 1 + 0.10, and t would be 4. The calculation of the future value:

$100 * [(1.10).sup.4] = $100 * 1.4641 = $146.41

Another way to look at this process is to ask how much money we would have to invest to come up with $146.41 after four years. The equation gets rearranged as:

PV = FV/[(1+r).sup.t] or PV = $146.41/[(1.10).sup.4] = $146.41/1.4641 = $100

Instead of compounding assets into the future, we are now "discounting" our end result back to the initial investment.

These examples of moving money around in time are at the heart of a basic rule of capital budgeting: Make investments that have a positive net present value, and don't make investments that have a zero or negative NPV. Investments that produce positive NPV raise the firm's net cash flow and increase prices and shareholder value.

Competing for Resources

But in the real world of business, investment decisions are far more complicated, and often more risky, than putting money in a savings account.

For example, if we want to invest $1 million this year in a project that will return several hundred thousand dollars each year for several years, does the project have a positive NPV? The answer depends on how much we get back and for how long, and calculations must take into account the varying cash flows in each of the years of the project as well as the expected cost of capital, which depends on the cost of debt and/or equity financing for the project. The cost of capital is usually provided by the CEO.

All of the future dollars to be earned must be converted in some way so that their values can be compared to the value of the current dollars that are to he spent, says Connolly. This is done on a spreadsheet that includes the interest or discount rate pins the expected cash flow for each year of the project. The cash flow is divided by the discount rate factor for each year, and the resulting numbers are added together. Subtracting the initial cost from that figure yields the NPV of the project. The equation for the calculation is:

NPV = -[C.sub.o] + E([C.sub.1])/(1+r) + E([C.sub.2])/[(1+r).sup.2] + ... + E([C.sub.T])/[(1+r).sup.T]

where [C.sub.o] is the initial cost, r is the discount rate (cost of capital), T is the number of years of the project lifespan, E([C.sub.1]) is the expected cash flow in year 1, and E([C.sub.T]) is the expected cash flow in the final year, year T. If the calculated NPV is positive, the investment is worthwhile, because the initial investment is less than the future cash flow--as adjusted through the formula into its equivalent in current dollars.

Business Services Industry

Accounting for time: to best evaluate and justify long-term expenditures, HR should understand how finance uses the keystone concept of net present value - Strategic HR

HR Magazine, Sept, 2003 by Steve Bates

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