Present Value of Future Cash in a Risky Situation

The most basic way of determining the present value of a future cash flow considers only 3 things:

1. How much cash are we talking about?
2. What is the interest rate that you could invest the cash in if you had it today instead of in the future?
3. How long is the future?  1 year?  2 years?

Why would you be receiving that future cash flow anyway?  Sometimes it’s cash that came from you.  Sometimes it’s cash as payment for services you rendered.  Consider the following three scenarios:

1. You put in $10,000 in a term deposit.
2. You lend $10,000 by buying a corporate bond.
3. You provide a service to a company which now owes you $10,000

In each case, the other party has an obligation to pay you back your money.  Is the chance that you will get paid the same?  It’s almost certain you will get your money back from the term deposit.  Even if the bank collapses, the $10,000 is most certainly covered by insurance.

The corporate bond is at risk if the company that issued the bond goes bankrupt.  How likely this is depends on who the company is.  A bond issued by an IBM is less risky than one issued by a smaller startup.

The company who owes you $10,000 may decide not to pay you at all.

Since the risk of not being paid in these scenarios is not different, there are two key things to note:

1. The value of the future cash flow should not be the same. 
2. You would normally want to be compensated for taking more risk.

The most basic means of computing the future cash flow, as outlined above, is not adequate for computing future cash flows that have a certain amount of risk in them.  The formula needs to incorporate the risk factor.

Present Value of Future Cash

 A thousand dollars in your hands today has more value than a thousand dollars promised one year from now. Why?

There's many reasons, but let's consider three.

First, if the cash was in your hands today, you could place it in an interest bearing facility, such as a time deposit.  In one year, that cash will earn additional money for you.  You could not do this with the thousand dollars promised to you 1 year from now.

Second, if you had the money with you today, any opportunity you come across between today and one year from can be acted upon.  If you don't have that money, you will end up not being able seize the opportunity.  Besides opportunities, you could also experience an urgent need for mpmey, as in the case of emergencies.

Third, for a long as the money is not in your hands, you are under the risk of not being paid your money.  In the case of a seller who sold a thousand dollars worth of merchandise to a buyer, should the buyer end up bankrupt, or for some reason unable or unwilling to pay the  money, the seller would be left with a thousand dollar loss.

So a thousand dollars today is worth more than a thousand dollars promised one year from now.  But how much more?

We can answer the question in two ways.  We can figure out how much a thousand dollars today will be worth one year frpm now. Conversely, we can  figure out how much a thousand dollars one year from now, is worth today.

The method of calculation can be as complicated as there are factors to consider, such as the risk of not being paid, the inflation rate, the possible opportunities to be foregone, and so on.  The simplest and most simplistic approach is to just consider the interest rate by which we can deposit the money if we had it in our hands today. This can be computed using the formula:

CV = PV (1 + i)^t

Where:

CV = cash value in the future
PV = cash value in the present (most commonly known as present cash value)
i = interest rate of a given time period (for example, the interest rate for 1 year)
t = the number of time periods to consider

Book Review of 'All You Gotta Do Is Ask' by Norman Bodek and Chuck Yorke

This is the kind of book that I would normally pick up at a bookstore shelf, flip through, and then return back to the shelf. It covers a topic that feels pretty shallow for a whole book.

The whole book, essentially, is about the benefits of putting up suggestion system within your organisation, and some tips and traps when you do so. The topic of an organisation putting up and maintaining such a suggestion system, to let it benefit from employees' ideas, and to boost their morale, sounds like something that can be covered by a web article or at most, a chapter in a book on continuous improvement.  A whole book on the topic feels like overkill, and I imagined it would contain a lot of fluff to pad it out.

But I noticed something in the blurb that attracted my attention.  The book’s author was Norman Bodek, the ‘founder of Productivity Press.’  As it happens, there are currently two publishers I automatically associate with material worth reading. 

One of them is 'Productivity Press', a publisher of books related to quality control and continuous improvement. They are especially known for introducing Japanese classics on these topics into the Western mainstream.  Although a fan of this publisher for many years, I did not know of Norman Bodek.  (The other publisher is The Free Press).

‘All You Gotta Do Is Ask’ is a simple book.  All it does is provide the motivation to implement a suggestion system, and provide proven tips and principles to make sure it is a success.

The book compares the average American company and a Japanese company which encourages its employees to send in suggestions.  The Japanese company receives anywhere from 50 to a couple of hundred ideas per year per employee. Of course, the latter receives the benefits, often in the range of millions of dollars in savings per year.  Almost literally, a goldmine for that Japanese company.

The book covers a whole range of topics about suggestion systems, including the psychological obstacles such as supervisors feeling threatened by inferiors suddenly realising they too possess a brain, or managers co-opting ideas and presenting them as their own, or employees being unsure what to suggest and therefore end up anxious.

In the appendix, you’ll find examples of actual improvement suggestions.  I was surprised by how mundane some can be. Here’s an example:

Before Improvement: It was hard to get a good grip on the shrink-wrap when trying to pull it off the spindle. 

After Improvement: Used a rag to hold on to the shrink-wrap to (tear) it off the spindle.

Simple as it is, it’s nevertheless an improvement. 

A key message the book continually injects is respect for the employees.  Managers must work hard to protect employees and their sense of self-respect. Ideas must be treated with respect.  This is particularly important because not all ideas will be good, and not all will be implemented.  It is important to balance reality. These are important, yet sensitive points, and the book provides recommendations on how to handle them.

There were some other useful insights.  Bodek and Yorke (the co-author) point out that the best suggestions for improvement are those that involve the suggester's work and how they can improve their own work.  It is quite easy to submit suggestions telling how others can improve how they work.  Such suggestions are useful, but because they impose on others, they are often resented, resisted, and not easy to implement.

The one thing I felt missing, which I think very important, is that the focus of the book was on employees coming up with ideas and solutions on how they can improve their own work. For professionals with a relatively large berth in terms of how they do their job, it feels weird to think about how to improve one's work and then put it up for suggestion. Most just execute their ideas for improvement without seeking (or being required to seek) approval. 

Overall, this is a short, easy-to-read book with good ideas about putting up and maintaining a suggestion system.  It cannot be the last word on the subject, but some of the ideas it presents are essential to a successful system.

Recommended.