1962 Economic and Valution Symposium, Dallas, March 15–16, 1962
In recent years a great deal has been said concerning the application of present value principles to the determination of an estimated rate of return on a proposed investment. Various methods of computing this return have been presented; and though they may differ in some mechanical aspects, the underlying concept of each is the same.
The purpose of this paper is (a) to point out a significant fallacy in the assumptions on which these procedures are based, a fallacy that must be corrected if the present value concept is to gain its proper acceptance in the evaluation of investment opportunities; and (b) to outline a method of calculating rate of return which incorporates the essential elements of present value for broad applicability and comparability but which corrects the major deficiencies of previous methods.
The approach I shall describe is intended to provide a figure that is far more consistent with the realities of company operations than is the case now. It is in the nature of a bonus that this new method is also considerably quicker and simplier than previous ones.
It should be wholly unnecessary to discuss the merits of present value itself with this group today. Surely its acceptance must be wholehearted by now in an industry where the time element of the investment decision and its attendant cash flow is so significant. One of the strongest and fullest cases for a present value method of determining rate of return has been presented by Ray I. Reul. His sound arguments for this basic concept have my fullest support and need no reiteration now. Present value accounts for the indisputable fact that money has earning power and that, therefore, a dollar received today is worth more than a dollar received sometime in the future. This is a principle that must be applied to rate-of-return evaluations in order to relate the varied time factors of cash flow and derive a meaningful index. It is with the application of this principle that we should be primarily concerned here.
In applying present value to a proposed investment, current methods generally use a trial-and-error approach to determine what rate of interest will equate (a) the discounted value of the stream of earnings from the investment and (b) the value of the investment itself. Thus, all elements of the investment and of the cash flow-back are reduced by random compound-interest factors to a base point in time until, by some means of interpolation if necessary, that rate is found at which the cash laid out for the investment and the cash returned by it become the same. This figure is considered the rate of return on the investment.
It is to one critical assumption underlying the usual procedure-that I take strong exception. The future receipts and payments are reduced to their present value by discounting them at the same rate as that which the proposed investment is estimated to provide. In other words, managers using this method automatically assume that, for the period between the base point and the time when the funds are spent or collected, the funds are, or could be, invested at the rate of return being calculated for the proposal.
This is simply not true. Indeed, it is only by coincidence that the two would be at all alike. The funds would be at work during the interim period not at a rate similar to that of the proposed investment, but at the average rate at which general corporate funds are being invested-at the over-all value of money to the company. An appraisal must be made by management as to what this value of money is now and what it is expected to be in the near future. What is the average return that will be gained on funds drawn from the melting pot of the company treasury?