Present value: Difference between revisions
imported>Doug Williamson m (Add link to Internal Rate of Return) |
imported>Doug Williamson (Update - source - Association of Corporate Treasurers - email from Naresh Aggarwal 16 Feb 2022.) |
||
| (24 intermediate revisions by 2 users not shown) | |||
| Line 1: | Line 1: | ||
''Investment appraisal.'' | |||
(PV). | (PV). | ||
Present value is the current equivalent value - of cash available immediately - for a future payment or a stream of payments to be received at various times in the future. | |||
The present value will vary with the discount (interest) factor applied to discount the future payments. | |||
Present value is today’s fair value of the future cash flow or cash flows, calculated by discounting them appropriately. | |||
The appropriate rate to discount with is the appropriately risk-adjusted current market [[cost of capital]]. | |||
==Calculation of present value== | |||
We can calculate present value for time lags of single or multiple periods. | |||
<span style="color:#4B0082">'''Example 1: One period at 10%'''</span> | |||
If $110m is receivable one period from now, and the appropriate periodic cost of capital (r) for this level of risk is 10%, | |||
the Present value is: | |||
PV = $110m x 1. | PV = $110m x 1.10<sup>-1</sup> | ||
= $100m. | = '''$100m'''. | ||
And more generally: | And more generally: | ||
PV = | PV = Future value x Discount factor (DF) | ||
Where: | Where: | ||
DF = (1+r)<sup>-n</sup> | DF = (1 + r)<sup>-n</sup> | ||
:r = cost of capital per period; ''and'' | :r = cost of capital per period; ''and'' | ||
:n = number of periods | :n = number of periods | ||
<span style="color:#4B0082">'''Example 2: One period at 6%'''</span> | |||
If $10m is receivable one year from now, and the cost of capital (r) is 6% per year, | |||
the Present value is: | |||
PV = $10m x 1.06<sup>-1</sup> | PV = $10m x 1.06<sup>-1</sup> | ||
| Line 31: | Line 52: | ||
<span style="color:#4B0082">'''Example 3: Two periods at 6%'''</span> | |||
Now | Now let's change the timing from Example 2, while leaving everything else the same as before. | ||
If exactly the same amount of $10m is receivable, but later, namely two years from now, | |||
and the cost of capital (r) is still 6% per year, | |||
the Present value falls to: | |||
PV = $10m x 1.06<sup>-2</sup> | PV = $10m x 1.06<sup>-2</sup> | ||
| Line 41: | Line 69: | ||
The longer the time lag before we receive our money, the less valuable the promise is today. | The longer the time lag before we receive our money, the less valuable the promise is today. | ||
This is reflected in the lower Present value for the two years maturity cash flow | This is reflected in the lower Present value ($8.90m) for the two years maturity cash flow, compared with the higher Present value of $9.43m for the cash flow receivable after only one year's delay. | ||
Even though the money amounts receivable are exactly the same, $10m, in each case. | |||
== See also == | == See also == | ||
* [[Adjusted present value]] | * [[Adjusted present value]] | ||
* [[Annuity factor]] | |||
* [[Compounding factor]] | * [[Compounding factor]] | ||
* [[Cost of capital]] | |||
* [[Discount factor]] | * [[Discount factor]] | ||
* [[Discounted cash flow]] | * [[Discounted cash flow]] | ||
* [[Economic value]] | |||
* [[Future value]] | * [[Future value]] | ||
* [[Internal rate of return]] | * [[Internal rate of return]] | ||
* [[Intrinsic value]] | * [[Intrinsic value]] | ||
* [[Investment appraisal]] | |||
* [[Net present value]] | * [[Net present value]] | ||
* [[Profitability index]] | * [[Profitability index]] | ||
| Line 58: | Line 91: | ||
* [[Time value of money]] | * [[Time value of money]] | ||
[[Category: | [[Category:Corporate_finance]] | ||
[[Category: | [[Category:Long_term_funding]] | ||
[[Category: | [[Category:Manage_risks]] | ||
[[Category: | [[Category:Trade_finance]] | ||
Latest revision as of 15:19, 16 February 2022
Investment appraisal.
(PV).
Present value is the current equivalent value - of cash available immediately - for a future payment or a stream of payments to be received at various times in the future.
The present value will vary with the discount (interest) factor applied to discount the future payments.
Present value is today’s fair value of the future cash flow or cash flows, calculated by discounting them appropriately.
The appropriate rate to discount with is the appropriately risk-adjusted current market cost of capital.
Calculation of present value
We can calculate present value for time lags of single or multiple periods.
Example 1: One period at 10%
If $110m is receivable one period from now, and the appropriate periodic cost of capital (r) for this level of risk is 10%,
the Present value is:
PV = $110m x 1.10-1
= $100m.
And more generally:
PV = Future value x Discount factor (DF)
Where:
DF = (1 + r)-n
- r = cost of capital per period; and
- n = number of periods
Example 2: One period at 6%
If $10m is receivable one year from now, and the cost of capital (r) is 6% per year,
the Present value is:
PV = $10m x 1.06-1
= $9.43m.
Example 3: Two periods at 6%
Now let's change the timing from Example 2, while leaving everything else the same as before.
If exactly the same amount of $10m is receivable, but later, namely two years from now,
and the cost of capital (r) is still 6% per year,
the Present value falls to:
PV = $10m x 1.06-2
= $8.90m.
The longer the time lag before we receive our money, the less valuable the promise is today.
This is reflected in the lower Present value ($8.90m) for the two years maturity cash flow, compared with the higher Present value of $9.43m for the cash flow receivable after only one year's delay.
Even though the money amounts receivable are exactly the same, $10m, in each case.
