What is Present Value?
Present value of a future cash flow is the amount of current cash that is of equivalent to the decision maker.
Compounding techniques is commonly used for adjusting for the time value of money. It increases an investor’s analytical power to compare cash flows that are separated by more than one period, given interest rate per period. Moreover, with the compounding technique, the amount of present cash can be converted into an amount of cash of equivalent value in future. However, it is very common practice to transform future cash flows into their present value.
One of the most important term that one needs to understand for better understanding of present value is discounting. Discounting is the process of determining present values of a series of future cash flows. The compound rate for discounting is known as discount rate.
Present Value of a Single Cash Flow
PV = F×PVF(n,i)
Here, F = Future Value
PVF = Present value factor of Re 1
For example, there is an investor who wants to find out the PV of Rs 50,000 to be received after 10 years. The interest rate is 10%.
So, PV = 50,000 × 0.386
Now suppose the same investor wants to know the worth of above investment to be received after 20 years.
Here, PV = 50,000 × 0.162
The PV declines for given interest rate as the time period increases. Similarly, given the time period, present values will decline as the interest rate increases.
Present Value of an Annuity
PV = A × PVFA(n,i)
Here, A = Annuity
PVFA = Present value of an annuity factor of Re 1
For example, A has borrowed 4 year loan of Rs 50,000 at 10% rate of interest from his employer for a bike. Now your employer requires 4 equal end of year repayments.
50,000 = A × 3.170