Present value

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Investment appraisal.

(PV).

Present value is today’s fair value of a future cash flow, calculated by discounting it 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.


See also