Understanding the power of Present Value calculations

“Present value is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk. Present value calculations are widely used in business and economics to provide a means to compare cash flows at different times on a meaningful "like to like" basis”.

(http://en.wikipedia.org/wiki/Present_value )

The most common mistake when performing a long term financial analysis is not calculating the Present Value of your planned future payments of different licensing agreement.

When you compare an Enterprise Agreement to a Select Plus agreement over a 6 year period and you spread out your payments over the 6 years you are actually looking at different periods in time where the value of your money is actually not yet determined. (EA is usually fixed equal payments and a Select Plus is usually spread out into varying sums of different periods),

In order to calculate the total sum of the planned payments you need to bring all future payments to a common point in time using the same “risk factor” or “Interest rate factor”.

This process requires 4 steps:

1. Decide on the number of years for which you will be performing the financial analysis
2. Find out your planned future payments
3. Decide on the Licensing Agreements to be compared
4. Determine your “risk factor” or “Interest rate factor” this could be done by using the CPI (Consumer price index) or your company’s return on investment rate obtained on investments

Example:

1. Financial time line – 6 years
2. Future payments – as per the below table
3. Licensing agreement – EA
   1. Option 1 – 2011-2013 Core Cal Only, 2014-2016 Full Platform
   2. Option 2 – 2011-2013 Full Platform, 2014-2016 Full Platform
4. Interest rate factor – 6%

Before Present Value calculation

 Including Present Value calculation

Conclusion

As you can see from the example, the difference between the PV calculation and the non PV is ~ 500K for a period of 6 years, this is a substantial sum of money that can be saved if planned carefully.