Present value is mostly a concept that is employed by financial advisors analyzing business opportunities from leases to share purchases and mergers and acquisitions. Present value explains the relation of 1 dollar today compared to 1 dollar tomorrow.
Example: Anrult Dermenage is selling a piece of real estate in Redwood City. The other day, he was offered $ 10, 000 for the property . Today, another buyer offered him $ 11, 424, however, the second offer is paid one year from today. Anrult has satisfied himself that both offerors are honest and fiscally solvent. He and his real estate broker believe that none of the offers will fall through or experience payment troubles . Which of the two offers should Anrult take ?
The answer depends on what Anrult will do with the cash he receives at this moment. If he has a way to
invest the money safely in a bank account and receive a 12 % interest, within a year he will possess $ 11, 200:
$ 10, 000 [return of principal] + (0. 12 * USD 10, 000 [interest he will get])= $ 11,200. Because this is less than the $ 11, 424 he will receive from his alternate buyer, Anrult should accept the second offer.
Another way of calculating this result uses the concept of present value. Present value tells us how much money must Anrult put in the bank today so he will have $ 11, 424 in the coming year? We can write this as
Present value * 1. 12 = USD 11, 424. Solving for Present value we get
PV = $ 11, 424/1. 12 which equals $ 10, 200. Commonly, the formula for the present value of an one period investment is normally written as:
PV = C1/(1 + r). When you despair about all the funny symbols, here the explanation: C1 is the cash flow at date 1 and r will be the appropriate interest rate, also sometimes called the discount rate.
Present value analysis tells us that a payment of $ 11, 424 received next year provides a present value today of $ 10, 200. This means that Anrult does not care whether you give him 10,200 today or 11, 424 next year, assuming a 12 % interest rate.
Because the second offer provides a present value of USD 10, 200 and the first offer has a present value of $ 10, 000, Anrult should accept the 2nd offer.
Both future value analysis and present value analysis result in the same decision.
This is a simple but powerful example. Financial analysts, real estate agents , accountants, all employ the present value and future value calculations regularly and of the many financial formulas, ratios, software and various other tools, this one is the most common and reliable. In an attempt to go back to the basics, here is the tool you should master.
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