Question

Why do you think present value is important when evaluating capital investments? Give an example of how you could use present value to make a decision in your current job.

Answer 1

Present value is pivotal because it provides the current value of the future cash flows. A comparison of projects on the basis of present value is more scientific, correct, conceptual and sensible than future value. Also, it takes the effect of inflations

For example,

Below are the operating expenses of Machine 1 and machine 2

Outflow	Machine 1	Machine 2	pv @15%	PV Machine 1	PV Machine 2
Year 0	100000	130000	1	1,00,000	1,30,000
Year 1	120000	20000	0.87	1,04,348	17,391
Year 2	70000	30000	0.76	52,930	22,684
Year 3	10000	40000	0.66	6,575	26,301
Year 4	10000	50000	0.57	5,718	28,588
Year 5	10000	60000	0.50	4,972	29,831
	320000	330000		2,74,542	2,54,795

If we use all the future values of Machine 1 and machine 2, then certainly machine 1 is more expensive to operate. However, if we take present value in consideration with interest rate as 15%, then present value of machine 1 is higher than Machine2.

In the normal scenario, machine 1 would have been selected because of lower outflow ie 320000. But in present value, machine 2 is better because the present value of outflow is lower than machine 2. Hence, the present value method is vital for business decision making.

Hi mate,

I would be grateful to you if you can provide a thumbs up and write one beautiful comment. It will improve my rating and let me continue my journey here.

In case of doubt, please comment. I will consider myself fortunate if I can help you.

All the best for your bright future.