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What Is Present Value?

what is present value

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