Compare Projects Using Time Value of Money

Reference: High Res Catching Time Hourglass Picture — Free Images (shopify.com)

Problem Statement

Consider there are two projects, first project

you are going to invest to 100K$ today and you are going to generate revenue 200K$ exactly after one year.

in the second project

you are going to invest 120K$ today and you are going to generate revenue 250K$ exactly after two years.

Let’s put the above problem statement in table format.

How do you compare and know which one of these two different projects more profitable?

Solution

Time and return rate plays very important role. You need to calculate the what is the worth of revenue as of today. In other words, what is the value of 200K$ (which you will get it in a year) as of today.

For that you can use following formula

Present value formula

PV → Present value

FV → Future value

r → return rate

n → number of periods

Let’s assume the return rate is 10% for the both the projects.

Using the above formula, the value of 200K$ as of today for project 1 is 181.8K$. In other words, we can say that, if we invest 181.8K$ and allow it grow by 10% interest rate, we will get 200K$ in a year.

Similarly the value of 250K$ as of today for project 2 is 206.6K$. In other words, if we invest 206.6K$ today and allow it to grow at the rate of 10% for two years, we will get 250K$ at the end of two years.
Let’s put it in table format,

Now we can compare the project 1 and project 2 because we know the present value of the revenue. So let’s calculate the net worth of each project as of today, that we can get by subtracting the present day invested value from revenue as of today. So for project 1 the net worth is,

181.8K$ (minus) 100K$ = 81.8K$

and for project 2 net worth is,

206.6K$ (minus) 120K$ = 86.6K$

Let’s update the above table for better comparison

So we can say that, project 2 is more financially worthy project to obtain since its net worth is higher than the project 1.

Conclusion

We need three things while comparing any projects using time value and money. We need invested amount, revenue and the time to generate that revenue. We also need to know the return rate and the most important the value of generated revenue as of today.

Reference:

Pricing Strategy Optimization | Coursera