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Challenges in advanced management accounting
Challenges in advanced management accounting

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3.3.1 Underlying factors

The risk that cash flows do not take place in the future

The future is uncertain and relying on predictions of the future carries risk. You can invest money now in the expectation of getting future cash inflows, but the expected inflows may not happen! For example, a counterparty that owes you money may go bankrupt, market conditions may change and sales may not meet the forecast levels, efficiencies from a new machine may not be achieved due to manufacturing problems or incorrect assumptions made. There are many things that may go wrong resulting in you not receiving some, or even any, of the money you were expecting, and the further into the future you have to wait to receive it, the more that can go wrong.

So the value of a future cash flow must be less than the same sized cash flow that takes place now or sooner in the future. This is summed up, loosely, in the phrase ‘a bird in the hand is worth two in the bush’, meaning it can be preferable to have something of lesser value now, rather than the risky prospect of gaining something of greater value in the future. The risk of a project is usually the major factor in choosing a discount rate for a project, because the risk involved with a project leads to a much higher discount rate than a discount rate based solely on inflation or the rate from investments such as bonds.

The loss of flexibility

During the time that the funds are invested and committed, an organisation loses the ability to use those funds for other opportunities that may arise. Sometimes other opportunities will present a higher return than that available from the project undertaken, but it is too late to change the organisation’s plan. The time value of money can reflect what opportunities an organisation might miss by committing funds to a project. In economic terms, having more options can only make you better off. At worst, you do not use the options and have the same wealth as before.

Committing funds to a project removes options, and there is a potential opportunity cost associated with this. In a way, this is the reverse effect of future cash flows having less value due to their risk. Money in the present has greater value compared to money in the future, because money now could be used to invest in other opportunities if they arise, so money now has some extra value compared with money in the future. Since cash flows in the future have less value, they should be discounted to reflect this.