Question

Explain why you might want to use a present value calculation when conducting a cost- benefit analysis.

Answer 1

soln.:

In a company while making decisions related to capital budgeting a company must consider the expected cost and compare with its forthcoming benefits but all are available on future value so it is very difficult to consider cost and benefit on equal terms, that is why the concept of npv that is net present value came into existence.

To understand it better lets start with the time value.

The money which we are using is having time value as it is effected by the rate of interest in respect with time (i.e. period of investment or saving).

let's assume a person is having some money in his locker and if it opens the locker after year the money will remain same but if he deposit the money in a bank which further invest the money then the depositor will get some increased amount after a period of time as that money will be lended by the bank to someone who needs it and charge a certain rate of interest and a certain part of that interest will be given to the dipositor as his share that is why holding of money is differ from investment.

Now let's discuss the present value suppose if a person eat $100 after a year and the market is so he has to invest only that much amount which will give him $100 with interest after an year which is about $90.90.

So as while conducting cost benefit analysis regarding some project for proposal we must consider present value of all future cost and benefits to nullify the effect of time value on the respective amounts. the concept of present value utilizes the methodology of discounting very effectively and gives the clear picture to perform cost benefit analysis.