Why cash flows of different periods are not comparable

The statement. Adding up the rupees a project brings in over several years and comparing the total with the investment assumes that a rupee has the same value whenever it is received: a rupee now equals a rupee at the end of year 1, which equals a rupee at the end of year 2. That assumption is incorrect, because money has a time value. A rupee in hand today is worth more than a rupee receivable after a year; a person parts with a rupee now only for something more than a rupee later, and that compensation is interest, the time value of money. Cash flows of different years are therefore in different units of value, and their absolute amounts cannot be compared or added.

Reasons money has a time value:

1. Preference for current consumption. Individuals generally prefer consumption now to consumption later.
2. Investment opportunities. Cash in hand now can be invested to earn more; that opportunity is lost if the cash comes later.
3. Uncertainty. The future is uncertain, so a present rupee is preferred to a promised future one; this is the most important reason.
4. Inflation. Rising prices reduce the purchasing power of a rupee received later.

How they are made comparable. Cash flows are brought to a common point of time using a rate of interest that reflects the time value of money, through two concepts:

• Compounding (compound value concept). Each present or earlier amount is carried forward to a future date: a rupee invested now at rate r grows to (1 + r)ⁿ after n years.
• Discounting (present value concept). Each future amount is brought back to today: a rupee due after n years is worth 1 ÷ (1 + r)ⁿ now.

Once every flow is expressed at the same date (usually the present), the amounts are comparable and can be added and set against the investment. This is the basis of discounted methods such as net present value.