Playbook: are you really saving money? How to financially evaluate a project using the concept of present value vs. future money.

Imagine you had a staff member who brought you a great idea to save costs. For an initial investment of $28,000 in new software, you would have great savings during the next three years. In fact, she projects it will save $5,000 the first year, $10,000 the second year, and $15,000 the third year, totaling $30,000 in three years--the software more than pays for itself! I bet at first glance, you may think that purchasing the software would be a no-brainer. Well, maybe it isn't.

Let's look at this specific example from a different approach. Certainly, your staff member is right--you'll spend $28,000 today, and save $30,000 during the next three years. However, today's money is worth more than to-morrow's money because money you have today could be invested to earn interest income, so saving that $15,000 in year three isn't really worth $15,000.

In order to evaluate whether or not this project (or any project) is financially sound, you need to determine what those future cash savings are worth. Here are three easy steps to do it:

Step One (Column A): Schedule the cash out and the potential cash savings.

Step Two (Column B): Determine your discount factor, which is the percentage at which the future money is "discounted" to make it equal today's dollars. The factor is calculated with a formula that uses the year of the cash flow and the interest rate that the money would earn if invested. Let's assume a five percent interest rate. The formula is:

1 / [(1+x).sup.n] where "x" is the interest rate and "n" is the year of the payment

So, in year 2, for example, the formula is: 1 / [(1+0.05).sup.2] = 0.9070

Step Three (Column C): Multiply the cash flow in column A with the discount factor in column B to determine the net present value of each cash flow. This amount equalizes all the future dollars, which are worth less, by discounting them into today's dollars.

Looking at it in reverse, if you had $9,070 today and you invested it and earned 5 percent per year for two years, you would have $10,000 (see chart on page 22).

By adding up the net present value cash flow streams in column C, you'll see that actually the project is going to lose money. Your staff member would have been financially better off investing the money. The concept of present value hinges on the fact that you need to treat today's dollars with more value than tomorrow's dollars. So the next time you are evaluating a potential project that has future savings or revenue, take a look at discounting those future savings to get a true financial picture.

FUN FACT

Speaking of investing, if you had invested $1,000 in Microsoft's initial public offering on March 13, 1986, how much money do you think the stock would be worth today?

a) $100,000 b) $360,000 c) $525,000 d) $840,000

Answer: (b) Your $1,000 investment would be worth just around $360,000. Microsoft has grown tremendously and has had numerous stock splits. Where's my time machine?

Rob Batarla is NRPA's director of finance. He has more than eight years of accounting and finance experience, holds an MBA, and is a certified public accountant. He can be reached at [phone] or by e-mail at [e-mail].

Present Money vs. Future Money

                             A            B             C

                        Cash Flows   Discount   Net Present Value
                                      Factor

Initial Outlay--Yr 0     ($28,000)    1.0000        ($28,000)
Cost Savings--Yr 1         $5,000     0.9524          $4,762
Cost Savings--Yr 2        $10,000     0.9070          $9,070
Cost Savings--Yr 3        $15,000     0.8638         $12,958

Totals                     $2,000                    ($1,210)