What Is Present Value
Present value refers to the current value of the sum of money that is received in some future date. This is done by discounting the future value of the money. To understand the concept of present value one first needs to understand the meaning of time value of money. This can be known by the time travel with which the value of money changes.
When money travels in time its value changes. One rupee in hand today has more value than that same rupee after ten years. This means that the value of money goes down with the passage of time. The value of the money today is called the present value and the value in the future is called the future value.
When the present value of a future amount needs to found the amount is discounted. Then the future value is discounted it is done at rate called the discount rate. The higher the discount rate the lower will be the present value of the amount. The same way the future value of a present amount can also be calculated.
Let us now consider why the concept of present value exists. This is because the money that is invested or will be available to the person in future may have been used some where else that will give some interest. The opportunity cost of letting that interest go should be less than the money that you will receive in the future.
The other reason why the future value should be considered is the investment risk that an investor takes up should be covered. This means that when the investor invests money somewhere he is undertaking a risk of that amount. This is uncertain that the amount will be returned. Hence to get the money back it should be something more.
The concept of present value is used more commonly to evaluate the projects and investments that an investor is planning to invest in. the investment is compared with the present value of the future returns. If the present value of the future returns is more than the present value of the investment then the investment would be worth considering.
Another important use of the concept of present value of money is for comparing of various projects. The projects that have a higher present value would be considered to be invested in. the cash flows, that is the cash outflow and the cash inflow should always be compared at the same time period by this we mean that the inflows, which is generally in future and the outflows should be brought to present value and then compared.