Present Value of a Sum That Would Be Paid in the Future
The present value concept captures the time value of money by adjusting through compounding and discounting cash flows to reflect the increased value of money when invested. The present value of a cash flow reflects in today’s terms the value of future cash flows adjusted to the cost of capital. In essence time value of money reflects the fact that money in hand today is more valuable than an identical amount of money received in the future and that benefits and costs are worth more if they are realized earlier. Since money, today can be interesting. All costs must be adjusted to reflect the inflation rate and then discounted to their present value. The time value of money reflects the idea that a dollar in hand today is worth more than a dollar in the future, even after making adjustments for inflation. The time value of money takes into account factors like (i) the number of time periods, (ii) the interest per time period, (iii) the present value that is the dollar amount today or at the beginning of the first time period and (iv) the future value that is the dollar amount at a later date or at the end of the last time period.
Example: When Mr. K wanted to sell a piece of land, he was offered $ 10,000 today and $ 11,424 after a period of one year. Present value analysis tells us that the payment of $ 11,424 to be received in the next year has a present value of $ 10,200 today. In other words, with an interest rate of 12%, Mr. K should be happy if he is paid $ 10,200 today or $ 11,424 next year. If he is paid $ 10,200 today, he would put it in the bank at 12% interest and receive $ 11,424 next year. Thus, present value analysis helps in investment decisions while considering alternative proposals offering different income possibilities. Especially when a company wants to invest large sums of money on large capital projects, present value analysis comes in handy in aiding the decisions.