Wealth Opportunities in Commercial Real Estate: Management, Financing, and Marketing of Investment Properties

The Time Value of Money: Present Value and Discounted Cash Flow

The end result in the Argus presentation is a cash flow for each of the next 11 years. How do you then determine value? Do you add up each one of these numbers to arrive at the total value? The answer is no. The answer lies in the concept of the “time value of money.”

What would you rather have: a dollar today or a dollar one year from today? Obviously, you would rather have one dollar today, because if you have the dollar today you can invest that dollar and earn a return so that the dollar at the end of the year would be worth one dollar plus three cents, if the rate of return on the investment was 3 percent. The converse also applies; that is, what would you pay today to have one dollar and three cents at the end of one year? If you assume a return of 3 percent, you would pay one dollar today. In the accepted nomenclature, the one dollar is referred to as the present value, the three percent is called the discount rate, and the one dollar and three cents is the future value. The discount rate is essentially the rate of interest, but because the calculation is to reduce value rather than increase value, it is referred to as a “discount rate.” The process of determining the present value of a stream of income is referred to as “discounting the cash flow.”

Applying the time value of money to our cash flow model involves the concept of discounting the cash flow. The objective is to determine the present value of the ...