Present Value

What is the meaning of Net Present Value?

Net Present value stands for the difference between the expected current inflow and current value of all cash outflows at a given rate over a period of time. A future cash value is discounted to obtain the current value. Discounting here stands for the process of applying a specified rate upon the future cash flows to convert it to the present monetary value. 

Net present value is used to calculate the profitability considering the current  and future cash inflow and outflows. It is believed that investment is good if the NPV of the projects is positive and it is not good to invest when the NPV is negative. NPV is calculated by first calculating the present value of the future inflows. The calculator inflows are discounted and thereafter added to the current outflow to calculate the Net Present Value.

How is the Present Value Calculated?

The present value calculation is done based on a mathematical formula derived.             

Present Value = Future Value  (1+ Rate ) n

Here,

• Present Value is the amount to be calculated
• Future value stands for the amount of cash flow to be converted into current value
• Rate here is the discounting rate
• N here stands for the number of years

Now,

For Example,

An investor receives Rs 1,00,000 after 4 years. Let’s suppose the interest rate is 15%. The present value of Rs. 1,00,000 before 4 years at the rate of 15% is Rs. 57,175. This means that the investor has to invest Rs 57,175 at 15% rate and after four years he would receive Rs 1,00,000. 

This difference in value between future money and present money arises due to the time value of money. Here the time represents the distance from money. The distance is believed to incur risk. That risk is calculated by applying a discount rate. Simply put, future money reduced by risk factor equals present cash flow. 

Let’s take an example,

Suppose, someone gives you an offer to take Rs 5,000 today or Rs. 5000 after 1 year. You shall select the option of taking the money today. The obvious decision is backed by various factors such as Interest rate and inflation. 

How does the Present Value Calculator work?

As seen till now, the present value is an amount compounded in reverse. A present value calculator is a financial tool to calculate the present value of any future amount given. The tool assists in calculating the current value of an amount that is to be received in the future. The tool consists of a formula box where the amount is fed. The rate of discounting and the number of years are stated separately. The calculator then calculates the current value of the future amount at that rate and over a particular period of time. 

The mathematical formula used above is used universally to calculate the present value of any future amount. 

PV = FV/ (1+r) ^n

Here 

PV = Present Value

FV = Future Value

R = Rate of discount

N = Number of years

The information to be mentioned on the Present Value Calculator

• Future Value which is to be converted to the present value
• Rate of return at which discounting shall be done
• Number of periods which generally states the number of years involved
• Present value is calculated thereafter

How is Present Value Annuity Factor calculated?

Present value annuity of all annuities is the cash flow of future annuity payments. The present value of the annuity is based on the concept of the time value of money. Simply stated the present value of annuity means the current value of all annuity payments. The present value of annuity states the value of a series of payments at any given period. 

PV of Annuity = P [1- (1+r) ^-n]/r

Where,

P = Periodic Payments

r = Rate per period

n = Number of Periods

There are certain assumptions considered while calculating present value of annuity. The assumptions are mentioned below

1. The periodic payment is stable and does not change.
2. The rate remains the same.
3. The first payment among a series of payments is one period away.

Conclusion

Present value is used every day in real life. The basic concept behind the term is that money earned today is worth much more than what is earned in the future. The present value of an amount is calculated after assuming that over the prescribed time, a return shall be earned depending upon a particular rate of return. Money invested today is believed to be worth additional interest to reach future value.