Present value: Difference between revisions
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==Calculation of present value== | |||
If $110m is receivable one | 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: | the Present value is: | ||
PV = $110m x 1. | PV = $110m x 1.10<sup>-1</sup> | ||
= '''$100m'''. | = '''$100m'''. | ||
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And more generally: | And more generally: | ||
PV = Future value x Discount factor(DF) | 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'' | ||
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'''Example 2''' | <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, | If $10m is receivable one year from now, and the cost of capital (r) is 6% per year, | ||
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'''Example 3''' | <span style="color:#4B0082">'''Example 3: Two periods at 6%'''</span> | ||
Now let's change the timing from Example 2, leaving everything else the same as before. | 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, | If exactly the same amount of $10m is receivable, but later, namely two years from now, | ||
Revision as of 20:16, 15 January 2016
(PV).
Today’s fair value of a future cash flow, calculated by discounting the future cash flow at 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 for the two years maturity cash flow of $8.90m, compared with $9.43m Present value for the cash flow receivable after only one year's delay.
