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Definition of Present Value
- The present value is the current value of future cash flows at a specific rate of return.
- The present value indicates that an amount of money today has a higher value than that same amount in the future.
- The present value is considered as the discounted value of the total revenue received from a given project.
What Impacts Present Value?
- Inflation decreases the purchasing power of money, as it causes the price of goods and services to increase.
- A decrease in the purchasing power of money causes a dollar a year from now to be worth less than a dollar today.
- People consider money as more valuable now because that money can be used to generate more money.
How To Calculate Present Value?
- To calculate the present value of future cash flows, you divide the future cash flow by the discounted rate at a specified number of periods.
- Present Value:
FV / (1 + r) ^ n
(Where FV = future value, r = rate of return, and n = number of periods.)
- Discount rate:
(1 + r) ^ n
-
- Future cash flows are discounted at the discount rate, resulting in the present value.
- The lower the interest rate, the higher the present value.
Why is Present Value Important?
- It is used as a guideline to judge the appropriateness of future financial gains and obligations.
- The present value is used to value stocks and bonds, to create financial models, and is crucial to many other aspects in Corporate Finance.
- When investing, the present value is used in order to understand whether or not it is worth making an investment in a particular firm.
- If the present value of future cash flows is greater than the actual investment, the project is profitable and is accepted.
Present Value in Practice
- There is the assumption that a rate of return could be earned on funds over time. However, no interest rate is guaranteed.
- Let’s say your father promises to pay you $300 for next year’s Christmas. What is the present value of that $300 if you can get 10% on your money?
- 500 / (1+0.1)1 = $454.55
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