Present Value


"Present value is what a dollar tomorrow is worth today."


So why are we interested that a dollar is worth more now than later? The reason is that it gives us a way to value a series of cash flows. If we can have a single number that values a cash flow, them we can compare cash flows to see which one is best. Let's consider a couple of cash flows:



What is so important about present value(PV)? Have your ever heard the expression "a bird in the hand is worth 2 in the bush?" PV is a little like that. A dollar today is worth more than a dollar a year from now. If it is not clear why, be sure to to watch the video on this page.


Now to determine how much more a dollar today is than a dollar a year from now, you have to think about interest rates. If your bank were offering 5% interest in a savings account, a dollar deposited now would be worth $1.05 in one year. We could also say that a dollar in our account one year from now would be discounted by 5% to get our PV of $.95. That is why the interest rate used for discounting is called the discount rate or sometimes the hurdle rate.


An Example


YearCash Flow #1Cash Flow #2

0-$15,000-$20,000
14,0003,000
25,0006,000
37,0009,000
4-2,0006,000
54,0001,000
65,0006,000

Would you make the investment in cash flow #1 or cash flow #2? Surprisingly it depends on the discount rate. For a discount rate of 10%, cash flow #1 wins with a present value of $1968 versus $1871 for cash flow #2. At 8% cash flow #2 wins at $3203 versus $2950 for cash flow #1.


Now that is confusing! Why can't we just make a simple decision about which cash flow is the best? Well, we first need to find out what a good discount rate is.


Discount Rate



The implication of the discount rate is that it is the minimum interest return that would be economical for us. If we are working with our savings, we might be satisfied with a hurdle rate that is about he same that we could expect on our savings or maybe 5%. If we are a company that is evaluating our capital budget, to see were we should invest our money to get the highest return, we would probably use our cost of money or the interest rate required to borrow money. Our interest cost might be 8%. Then we might add in something that would represent our expectation for inflation. We might decide that we will not accept any project that does not give a positive net present value with a 10% discount rate. When we are comparing cash flows, the winner is the one with the largest positive cash flow.


The Winner Is....


Back to our example cash flows. Both cash flows have a positive net present value. (By the way, when we are netting or adding all the negative and positive present values together, then it is called net present value or NPV) Since the NPVs are positive they have passed the "test." So, if the 2 projects are not mutually exclusive then we want the one with the highest positive NPV.


NPV or IRR?


When asked to evaluate cash flows some people prefer to use internal rate of return (IRR). Why? Because it is somewhat more intuitive than NPV. When you say that you have an IRR of 10% on a series of cash flows, it is like saying that you are earning 10% interest on your money. The method for calculating NPV is much easier than for IRR. However, with computers to help who cares?


What is the relationship between NPV and IRR? They are very intimately related. For a series of cash flows, the IRR is equal to the discount rate when the NPV=0. Expressed as an equation, it is:


If NPV = 0, then IRR = Discount Rate.


Summary


PV and its summed up cousin, NPV are valuable methods for comparing cash flows. When we pick a discount rate that we are happy with we can compare cash flows to see which one is best. This process is used as the basis for capital budgeting.


NPV Calculator - Calculate the NPV for a series of cash flows.




© 2006 - 2013 Stellar Force



Google


"present value" - Google News
"present value" - Google News
Google News

What is the intrinsic value of Johnson & Johnson (JNJ) - Simply Wall St - Sim...
26 May 2017 at 10:05am

What is the intrinsic value of Johnson & Johnson (JNJ) - Simply Wall St
Simply Wall St
In this article I am going to calculate the intrinsic value of Johnson & Johnson (NYSE:JNJ) by estimating the Future Cash Flows and discounting them to their ...

and more »

America's fiscal sword of Damocles - The Seattle Times
20 May 2017 at 9:02am

The Seattle Times

America's fiscal sword of Damocles
The Seattle Times
The fiscal gap is the present value difference between all projected future government spending obligations (including official debt service) and all projected future tax revenues. The ?all? is key. The fiscal gap puts everything on the books. Since ...

and more »

How Much Is My Bond Worth? - Madison.com
25 May 2017 at 8:20am

Madison.com

How Much Is My Bond Worth?
Madison.com
A bond's current market value depends on its own interest rate, or coupon rate, along with its face value and the current market interest rate. There is a mathematical formula to calculate how much your bond is worth, but simply put, rising interest ...

and more »

Is Alkermes plc (ALKS) worth $57.71 based on its intrinsic value? - Simply Wa...
24 May 2017 at 7:00pm

Is Alkermes plc (ALKS) worth $57.71 based on its intrinsic value?
Simply Wall St
In this article I am going to calculate the intrinsic value of Alkermes (NASDAQ:ALKS) by estimating the Future Cash Flows and discounting them to their present value. A discounted cash flow (DCF) analysis represents the net present value (NPV) of ...

and more »

An intrinsic value calculation for Swift Transportation Company (SWFT) shows ...
25 May 2017 at 12:47pm

An intrinsic value calculation for Swift Transportation Company (SWFT) shows its 21% undervalued
Simply Wall St
Does the May share price for Swift Transportation (NYSE:SWFT) reflect its intrinsic value? I am going to calculate it now by estimating the Future Cash Flows and discounting them to their present value. A discounted cash flow (DCF) analysis represents ...

and more »

Critical Thinking Skill #3 - The Time Value Of Money - Seeking Alpha
23 May 2017 at 1:49am

Critical Thinking Skill #3 - The Time Value Of Money
Seeking Alpha
When we consider the time value of money, the ideas of compound growth, the present value of money to be received in the future, and the impact of changing interest rates are just three examples of how the passage of time influences the wealth creation ...


Pennsylvania Pension Bill Could Save $18 Billon - Chief Investment Officer
19 May 2017 at 9:35am

Pennsylvania Pension Bill Could Save $18 Billon
Chief Investment Officer
For the first five years, the bill is projected to increase employer contributions by $2.5 billion on a cash-flow basis, or $2.2 billion at a 3.6% present value. For fiscal years ending between 2023 and 2035, employer contributions are projected to ...


IOG sets Blythe, Vulcan FDP plans - OE Digital
26 May 2017 at 10:58am

IOG sets Blythe, Vulcan FDP plans
OE Digital
The company says that its latest economic forecasts estimate that Blythe has an un-risked net present value (using a 10% discount rate) in the region of US$44.7 million (35 million), with a life-of-field average breakeven gas price in the range of 24 ...

and more »

Running for Your Life? Not So Much - American Enterprise Institute
28 Apr 2017 at 7:40am

Running for Your Life? Not So Much
American Enterprise Institute
Using a 10 percent discount rate, the present value cost of running two hours a week for 36 years is 1,006 hours, while the discounted present value benefit of 3.2 years is just 824 hours. Put differently, if you discount the value of your future time ...

and more »

Ford Is A Buy On The Dip - Seeking Alpha
26 May 2017 at 12:43pm

Ford Is A Buy On The Dip
Seeking Alpha
The recent discussion around an industry down turn has compelled many investors to sell the stock. Ford is still undervalued even after factoring in a severe cyclical decline. As a cherry, the 5% dividend is safe and will also be safe during the ...



Newsfeed display by CaRP
Share this page