"That makes no sense", I told a business manager. "Why would we pay $100 per month for that service when we could buy a compute platform to run it for $3000? It pays for itself in two and a half years." I was convinced that these office-dwellers had no idea how to multiply.
Years ago, I was a simpleton on the topic of business investing. It was not obvious to me why cloud services were such a useful offering when, in many cases, the recurring cost of cloud exceeded the up-front investment of building things in-house, even across just a few years. It is true that I also failed to properly account for the hidden operating costs of running your own server, such as electricity, cooling, and basic lifecycle management. This blog isn't a discussion on those costs, but rather, the time value of money.
The concept suggests that a dollar today is worth more than a dollar tomorrow. The common rationalization supporting this assertion relies on currency inflation and the option to invest today's cash to earn interest. Both are obviously true, but I want to focus on two more: risk and uncertainty.
Imagine living in a world where inflation and investing didn't exist. Would you still want cash now versus cash later? I would. If you are owed money in the future, there is a risk that your debtor fails to repay (US mortgage crisis circa 2008). Or perhaps you run a business and have approved a large cash investment to purchase new machinery. Your staff suggests you'll see a positive cash flow from operations via increased sales in 2 years. They say you'll really see sales growth in 5 years. The accuracy of a sales forecast decreases rapidly the further into the future it attempts to predict ... quite uncertain in my view. How does one quantify risk and uncertainty?
If you have a good staff, they've attempted to discount the value of those future cash flows. No, I don't mean discounts like "half price" or "BOGO". In this context, the discount rate tries to account for risk and uncertainty by reducing the value of future money, both inflows and outflows. Coming up with a discount rate is tricky and outside the scope of this post, but higher rates imply greater risk. Those investing in Venezuela today should use a high discount rate, say 20%. Investing in the US or Germany, maybe 5%. As for my $3000 server example, would it really "pay for itself" in a couple years?
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