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. Do not forget to use APA format on your sources and in-text citations.

Answer 1

Present value , a single most important concept in finance, is based on time value of money--ie. Same quantum of money received today is worth more than that received a year or two , from today--the more the time, the less its value as of today, ie. Time 0. Putting the other way round, $ 110 at end of 1 yr. from now, is worth $ 100 today , discounting at the rate of 10%,ie. 110/1.10^1= $ 100 or 100*1.10=$ 110. Amount received now , can be gainfully invested , by earning interest .

That said , capital investment analysis requires estimating future cash inflows as well as outflows , all occuring at some point of time in future.

Depending upon the probability /certainty of the quantum & occurrence of these cash flows and also after considering the cost of finance to fund the project,the company decides upon the discount rate to be used to discount these cash flows, to bring them ,to their present values.

Comparing the cash flows (both inflows & outflows)that occur at different points of time, during the life of the project,by bringing them to their respective present values--by applying appropriate present values --and subsequently analysing the net present values(ie. PV of inflows-PV of outflows), the company will be able to select from among the alternatives--that which returns higher NPV.

This sort of comparison of cash flows , on an even plane, is made possible ,only by the concept of present value, which assigns time value to the entire project's cash flows.

An example of how the concept of present value can be used to make a decision in your current job

Suppose you want to accumulate $ 300000 at the start of your retirement , which is 20 years from now, and you know that your funds/ savings earn an interest of 8% p.a.

by applying the present value concept of money, you can decide how much to set aside now, at this interest rate that is used as discount rate,

which works out to -- 300000/(1+0.08)^20= $ 64364

so, you can plan , how to arrange this money --whether as one lumpsum or by periodic investment in some deposit a/c ?

If you afford & decide as one lumpsum, you can just decide to put $ 64364 in one 8% earning deposit a/c & just simply bide time.The amount of

If you afford & decide as one lumpsum, you can just decide to put $ 64364 in one 8% earning deposit a/c & just simply bide time.The amount of

If you cannot afford to save all at once, you can decide to save by making   periodic investments (annuities)in some deposit a/c for , whose present value is $ 64364 for 20 end-of- years, at 8% interest p.a.

Using PV of ordinary formula, we can find out the annuity (equal) amt. of deposit at end of year for 20 years =

64364=Annuity amt.*(1-1.08^-20)/0.08   which works out to $ 6556 per year.

You need to deposit $ 6556 every year , so that your retirement goal of$ 300000 accumulation is met.

Thus the time value of money concept , in general , and present & future values , in particular, are indipsensable ,for any type of financial planning, be it business or personal--- without which calculations will not also be accurate.