The present value concept is the exact opposite of that of a sum of money or series of payments, while in the case of present value concept, we estimate the present worth or a future payment/instalment or series of payment adjusted for the time value of money.
The basis of present value concept approach is that the opportunity cost exists for money lying idle. That is to say, that interest can be earned on the money. This return is termed as ‘discounting rate’.
Given a positive rate of interest, the present value concept of the future Rupee will always be lower. The technique for finding the present value is termed as ‘discounting’. The present value after ‘n’ Years:
PV = A
PV = Principal amount the investor is willing to forego at present.
I = Interest rate.
A = Amount at the end of the period ‘n’.
N = Number of years.
With this formula, we can directly calculate the amount, any depositor would be willing to sacrifice at present, with a time preference rate or discount rate of x%.
Example: If Mr X, depositor, expects to get Rs. 100 after one year, at the rate of 10%, the amount he will have to forego at present can be calculated as follows:
PV = A
PV = 100 = Rs. 90.90
Similarly, the present value of an amount of inflow at the end of ‘n’ years can be computed.
Present Value of a Series of Cash Flows
In a business situation, it is very natural that returns received by a firm are spread over a number of years. An investment made
now may fetch returns a certain time period. Every businessman will like to know whether it is worthwhile to investor forego
a certain sum now, in anticipating of returns he expects to earn over a number of years. In order to take this decision he needs
to equate the total anticipated future returns, to the present sum he is going to sacrifice. The estimate of the present value of
future series of returns, the present value of each expected inflow will be calculated.
The present value of series of cash flows can be represented by the following:
PV = C/(1+i) + C/(1+i)(1+i) + C/(1+i)(1+i)(1+i) + C/(1+i)(1+i)(1+i)(1+i)…….
PV = sum of individual present values of each cash flow: C1, C2, C3……….
Cn = Cash flows after period 1,2,3………….n.
I = Discounting rate.
However, a project may involve a series of cash inflows and outflows. The computation of the present value of inflows by the above equation is a tedious problem.