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VMC: What Is Present Value?

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Definition of Present Value

  • The present value is the current value of future cash flows at a specific rate of return.
  • The present value indicates that an amount of money today has a higher value than that same amount in the future.
  • The present value is considered as the discounted value of the total revenue received from a given project.

What Impacts Present Value?

  • Inflation decreases the purchasing power of money, as it causes the price of goods and services to increase. 
  • A decrease in the purchasing power of money causes a dollar a year from now to be worth less than a dollar today.
  • People consider money as more valuable now because that money can be used to generate more money.

How To Calculate Present Value?

  • To calculate the present value of future cash flows, you divide the future cash flow by the discounted rate at a specified number of periods.
  • Present Value:

FV / (1 + r) ^ n

(Where FV = future value, r = rate of return, and n = number of periods.)

  • Discount rate:

(1 + r) ^ n

    • Future cash flows are discounted at the discount rate, resulting in the present value.
    • The lower the interest rate, the higher the present value.

Why is Present Value Important?

  • It is used as a guideline to judge the appropriateness of future financial gains and obligations.
  • The present value is used to value stocks and bonds, to create financial models, and is crucial to many other aspects in Corporate Finance.
  • When investing, the present value is used in order to understand whether or not it is worth making an investment in a particular firm.
  • If the present value of future cash flows is greater than the actual investment, the project is profitable and is accepted.

Present Value in Practice

  • There is the assumption that a rate of return could be earned on funds over time. However, no interest rate is guaranteed.
  • Let’s say your father promises to pay you $300 for next year’s Christmas. What is the present value of that $300 if you can get 10% on your money?
  • 500 / (1+0.1)1 = $454.55

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DISCLAIMER: This content is for information purposes only. It is not intended to be investment advice. Readers should not consider statements made by the author(s) as formal recommendations and should consult their financial advisor before making any investment decisions. While the information provided is believed to be accurate, it may include errors or inaccuracies. The author(s) cannot be held liable for any actions taken as a result of reading this article.

Posted in Valuation Master Class