Introduction
We know that the money we are having in hand now is more valuable than the money collected later. This is due to the fact that we can make money right now by putting the money in business, purchasing something, selling it later like stocks or depositing in the bank to earn interest. But the future money is always less valuable. This is known as time value of money (TVM). Future money is always less valuable due to inflation. So how do we compare the value of money now and the value of money in the future. This is where we need to understand the present value of money.
Definition of Present Value
Present value is defines as the value of the future sum of money given a specified rate of return. So it is the "value of tomorrow's cash flows". It determines the value of any currency today which in more than the future.
For example, if we want to invest for 10 long years in order to buy a car and the amount to purchase the car should be $ 10,000 in 10 years. So how much to invest now in the deposit account with a 5% interest rate so that it comes to $ 10,000 in 10 years. To know this value we need to present value of the money. The result is derived from a particular formula and the amount after calculating will be $6,139.13. Thus, $6,139.13 is worth $ 10,000 in 10 years if someone earns 5% each year.
Why companies need to use the concept of Present value
When the manager of company is required to compare the projects and the decide which one to go for then there are some methods that help the manager to take such decision. They are internal rate of return, pay back method and net present value. It is tool that is preferred by most financial analysts. It calculates the value of money by converting future cash flows to the present currency. It also provides a specific number that the manager can use to compare the initial amount of money spent against the present value of the return. Any time a company is using present money for future returns this method is always very helpful.
Calculation of the Net Present Value
For financial calculations and the determining the value of the invested money in the future it is important to know the calculation of net present value. Net present value (NPV) is determined by the difference between the net present value of cash flows and outflows. It is determined by the formula of
NPV= Ʃ Ct ⁄(1+r)t - Co where
Ct = net cash flow during the period t
Co= total initial investment costs
r = discount rate
t= number of time periods
After getting the result from the above method if the net present value (NPV) is positive it means that the projected earnings generated by a specific project is greater than the anticipated costs. So a positive NPV will be more profitable for the company while a negative NPV will result in the loss for the company.
References
Gallo, A. (2014) A Refresher on Net Present value. Harvard Business Review.
Retrieved from https://hbr.org/2014/11/a-refresher-on-net-present-value
Graham, R. How to calculate Present Value with Time value of Money. Managerial economies
for Dummies. Retrieved from www.dummies.com/how-to/content/how-to-calculate-present-value-with-time-value-of-money
