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

Proposed Regulations Update Mortality Tables, Minimum Present Value Requireme...
8 Mar 2017 at 7:51am

Proposed Regulations Update Mortality Tables, Minimum Present Value Requirements for Defined Benefit Pension Plans
The National Law Review
On November 25, 2016, Treasury and IRS issued proposed regulations that would update the minimum present value requirements applicable to certain distributions from defined benefit pension plans. The following overview summarizes these proposed ...


Cinema, Chimera: A Critically Endangered Species Director Zachary Cotler on t...
12 Mar 2017 at 8:22am

Filmmaker Magazine

Cinema, Chimera: A Critically Endangered Species Director Zachary Cotler on the Present Value of Difficulty
Filmmaker Magazine
Set in the literary world and dealing with a dying poet and novelist with an unusual end-of-life proposal, the Lena Olin-starring A Critically Endangered Species is directed by two filmmakers who know something about the world of their film. Magdalena ...

and more »

United States: Proposed Regulations Update Mortality Tables, Minimum Present ...
23 Mar 2017 at 11:09am

United States: Proposed Regulations Update Mortality Tables, Minimum Present Value Requirements For Defined ...
Mondaq News Alerts (registration)
On November 25, 2016, Treasury and IRS issued proposed regulations that would update the minimum present value requirements applicable to certain distributions from defined benefit pension plans. The following overview summarizes these proposed ...

and more »

Why Book Value Can Be Misleading - GuruFocus.com - GuruFocus.com
29 Mar 2017 at 9:11am

GuruFocus.com

Why Book Value Can Be Misleading - GuruFocus.com
GuruFocus.com
Book value is a fundamental part of value investing. The metric is important because it gives a core value of a company. In theory, if a business declared ...
The Buffett Series - Buffett on Book Value - ValueWalkValueWalk

all 4 news articles »

Silicon Motion Technology Corporation (SIMO) is trading at a 42% discount to ...
29 Mar 2017 at 3:54pm

Silicon Motion Technology Corporation (SIMO) is trading at a 42% discount to its intrinsic value
Simply Wall St
I am going to run you through how I calculated the intrinsic value of Silicon Motion Technology (NASDAQ:SIMO) by taking the expected future cash flows and discounted them to the value today. Discounted cash flow (DCF) is a valuation method used to ...

and more »

What is the intrinsic value of Exact Sciences Corporation (EXAS) - Simply Wal...
27 Mar 2017 at 12:14pm

What is the intrinsic value of Exact Sciences Corporation (EXAS)
Simply Wall St
In this article I am going to calculate the intrinsic value of Exact Sciences (NASDAQ:EXAS) using a method called discounted cash flow or DCF. A discounted cash flow (DCF) analysis represents the net present value (NPV) of projected cash flows to a stock.

and more »

What is the fair value of IPG Photonics Corporation (IPGP) - Simply Wall St
28 Mar 2017 at 5:24pm

What is the fair value of IPG Photonics Corporation (IPGP)
Simply Wall St
In this article I am going to calculate the intrinsic value of IPG Photonics (NASDAQ:IPGP) using a method called discounted cash flow or DCF. A discounted cash flow (DCF) analysis represents the net present value (NPV) of projected cash flows to a stock.

and more »

Camber Energy To Present At The IPAA 2017 Oil & Gas Investor Symposium - Yaho...
29 Mar 2017 at 2:20pm

Camber Energy To Present At The IPAA 2017 Oil & Gas Investor Symposium
Yahoo Finance
... and natural gas reserves and the present value thereof; legal proceedings and/or the outcome of and/or negative perceptions associated therewith; planned capital expenditures (including the amount and nature thereof); increases in oil and gas ...

and more »

SuperCoach 2017: 10 players who present value at new clubs - Herald Sun
5 Mar 2017 at 5:26pm

Herald Sun

SuperCoach 2017: 10 players who present value at new clubs
Herald Sun
SuperCoach 2017: 10 players who present value at new clubs. Herald Sun. March 5, 2017 4:27pm. A NEW club can revive a player's career ? and SuperCoach scoring potential. Just look at Sam Docherty. He went from an average scorer at Brisbane to the ...


Home Depot - Filing Season Finds: Week Of March 20-24 - ValueWalk
29 Mar 2017 at 12:44pm

Home Depot - Filing Season Finds: Week Of March 20-24
ValueWalk
HD has $7.5 billion in operating lease obligations with a present value of $5.7 billion. These leases are economically equivalent to debt and assets on the balance sheet?and in fact companies will soon be required to account for them on the balance ...

and more »


Newsfeed display by CaRP
Share this page