Question

1) Why is it important to be able to understand (or calculate) the present value of an investment, project, or future cash flow?

Answer 1

Many of the financial problems involve cash flows occurring at different points of the time. For evaluating such cash flows, an explicit consideration of the Time Value of money is required.

All of us generally prefer getting or having a certain amount of cash now i.e., at present rather than the same amount at some future time. This is called time preference for money. In other words, most or rather all of us value the receipt of money now or at present higher than waiting for some time to get the same amount at the same future time.

The value of money received today is more than the value of money received after some time in the future due to the following reasons:

(i) Inflation: Under inflationary conditions the value of money expressed in terms of its purchasing power over goods and services declines.

(ii) Risk: Having one dollar now is certain where as one dollar receivable tomorrow is less certain. That is a bird-in-the-hand principle is most important in the investment decisions.

(iii) Personal Consumption Preference: Many individuals have a strong preference for immediate rather than delayed consumption. The promise of a bowl of rice next week counts for little to the starving man.

(iv) Investment Opportunities: Money like any other commodity has a price. Let us assume that interest rate is 6% p.a.Given the choice of $1000/- now or the same amount in one year’s time, it is always preferable to take $1000/- now, because it could be invested over the next year @ 6% interest , to produce $1,060/- at the end of year. If the risk-free rate of return is 6%, then you would be indifferent in receiving $1000/- now or $1060/- after one year. In other words, the present value of $1060/- receivable one year hence is $1000/-.

Hence, due to above mentioned reasons, it becomes absolutely necessary to find out present value to evaluate a project or an investment decision which involves future cash flows