Question

Define present value vs future value.  In what scenarios would each method be used?

Answer 1

Definitions:

An amount of money receiving or paying in future if converted in present worthiness based on the discount factors is known as present value.

All sorts of future cash flows in respect of adding interest on present value is known as future value.

Scenarios of present value:

No.1) capital budgeting: this is used in capital budgeting process for finding which project is viable based on the expected rate of return. Basically, the project having higher present value should be considered.

No.2) borrow funds: in case of taking loan through financing activity what will be the periodic payments should be calculated through present value formula. The amount of loan here is the present value.

Scenarios of future value:

No.1) annuity: this is used in case of future annuity – suppose an equal sum of money is invested in bank on recurring basis what would be the future accumulation on that fund based on the interest calculation.

No.2) compound interest: this is used in case of lump-sum money accumulates in future if interest is charged on periodic compounding like yearly or monthly.