Suboptimal procurement, deployment, and distribution of financial capital lead to the suboptimal use of natural resources, labor, and innovation in an economy. We are focused in this course around optimal DEPLOYMENT.
The capital chain starts with capital that is used to buy assets to create products that generate sales and increase net income. Financial ratios can help analyze how efficiently we are managing the capital chain.
All goods and services are influenced by time. The utility of cash is future cash flows, and those cash flows are influenced by time. $100 now vs. receiving in 5 years changes the value. Next we will look at how this can be calculated.
The next part seems intimidating but it’s really cake. You know intuitively that getting $1,000 now isn’t the same as getting it in 5 years. There is a lot you could have done with that cash (invest it in the stock market, etc.). So, what is $1,000 in 5 years really worth right now?
You could invest it somewhere else and get a return, but you also need to factor in some risks in case someone won’t pay up. Those are accounted for in the “discount rate” (4% in this case, but it can be whatever you want).
Let’s break this beast down. PV, that’s what you are trying to figure out (worth today). CFt—that’s just the lump sum in the future, so $1,000 in this case. (l+r), that’s just adding 1 + 4%. t—That’s just 5 (5 years). BAM! Now you know what it’s worth.
Armed with this power, you can tell whether or not a $2,000 mower is really worth the investment when you look at the cash flow it will bring in down the road.