Question

Provide two examples of the use of present value techniques in accounting.

Please have at least 350 words and provide a reference please.

Answer 1

Example 1: You expect to get a gift from your grandmother of $100,000 in 5 years. You want to know what is the present value of this with an average inflation of 5%

Solution 1: Here , the 100,000 is the future value (FV) since it is received at a future point of time. So

FV = 100,000, r =5% =0.05 and n= 5 years

PV = FV/(1+r)^n = 100,000/(1+0.05)^5 = 100,000/1.05^5 = $78,352.62

So, the present value of the gift that you expect to receive from your grandmother in 5 years is $78,352.62

Example 2: You expected to get an annuity in your retirement which is $45,000 per year for 20 years. At an inflation of 5%, we can calculate the present value of this annuity

Solution 2: PV of an annuity = P*(1-(1+r)^-n)/r = 45,000*(1-(1+0.05)^-20)/0.05 = 45,000*(1-1.05^-20)/0.05 = 45,000* 0.62311/0.05 = 560,799.47 = 560,800 (Rounded)

So the present value of an annuity of 45,000 for 20 years at 5% is $560,800

In this manner, we can calculate the present value of a single amount (Example 1) and the present value of an annuity (Example 2).