How to Calculate the Present Value of Investments
The ability to estimate the value of something today that will change value over time is essential not only to buying and selling assets, it’s also a critical element of tracking the progress and efficiency of capital assets within an organization.
When you purchase a piece of capital like a machine you may have some estimates of the value that it will create for your organization and you may even have some projections on the returns on investment it will generate, but you can’t just sit back and assume your estimates were correct.
By tracking the amount of value it actually produces at specific intervals of time, you can check to see how accurate you were and make adjustments along the way. This becomes especially important if you plan to sell that capital, if you’re buying used capital, or if you deal with any sort of other investments such as bonds or derivatives.
Take a closer look at earnings
When you calculate present value, what you’re actually doing is looking more closely at earnings or cash flows that you or your corporation will make in the future. For example, you can apply present value to bond investments in which the investor knows exactly how much money he will earn nominally and when (the exact date) he will receive that money.
In cases like this, where you know all the information upfront, you can determine how much of the total future value you have already accumulated at any given point by using the following equation:
PV = FV / (1 + rt)
Here’s what the variables in this equation mean:
PV = Present value
FV = Future value
r = Rate
t = Time (in years)
1 = Percentage constant
To put this equation to use, consider this example: The interest rate for a one-year investment is 5 percent and the future value is $100. To find the present value, simply plug and chug:
PV = $100 / (1 + 0.05 x 1)
PV = $100 / 1.05
PV = $95.24
So the present value for this example is about $95. If the interest rate were only 4 percent, then the present value of a $100 future cash flow would be about $96. The present value is higher in this case because the difference between the present value and the future value is smaller given the lower interest rate.
Another way of looking at present value is that the more interest you earn or pay on future cash flows, either by way of higher interest or longer-term holdings, the less the present value will be. In the case of higher interest, the present value will increase at a much faster rate over time, while longer-term holdings will increase at the same rate but simply take longer to fully mature.
Being able to determine the present value of each potential investment, purchase, or cash flow before committing to it can help you and your company make the best possible decisions.
For instance, in making a large purchase that could include multiple payments, you can calculate whether your company would be better off paying for the item outright or making monthly payments with interest while keeping the remaining funds in an interest-generating account of some sort.
Discounted cash flows
Another term for present value is the discount value, which comes from the fact that you’re taking a known future value and discounting it at the interest rate in question. The reason for this distinction in nomenclature is that discount rate and discounted cash flows are really just a lot easier to say than present value calculation rate or present value rate of future cash flows.
Beyond that, there’s no difference. The only functional difference from present value is that this discussion is specifically about exchanges in cash rather than simply value generated. In other words, cash flows instead of value, but present value and discounted value don’t have a functional difference.
That being said, discounted cash flows refers to a situation in which multiple cash flows will appear on a single transaction. For example, when your company purchases a large item, each cash payment you make is considered a cash flow.
When your company invests in a coupon bond, each payment you receive is a cash flow. If your company purchases a machine for producing inventory, then both the future costs of buying and operating that machine and the value of the inventory created by that machine in the future are measured as discounted cash flows, whereby each individual cash flow is discounted to its present value.
Even though each cash flow will likely have the same interest rate, each one will have a different present value because each one is at a different point in time. So the present value of the most chronologically distant cash flows will be the lowest.
Here’s what the discounted cash flow equation looks like:
DCF = [CF1 / (1 + rt)1] + [CFn / (1 + rt)n]
The variables in this equation are fairly simple to define:
DCF = Value of discounted cash flows
CF1 = Cash flow number 1
r = Rate
t = Time (in years)
CFn = Cash flow number n; whichever cash flow you want to measure (often, but not necessarily, treated as the last cash flow)
1 = Percentage constant
All this equation really means is that you add up all the present values of future cash flows to determine the value of discounted cash flows, also known as the net present value.
When you add up all the discounted cash flows of a particular account, investment, or loan, you get a value called the net present value (NPV). For now, you really just need to know that if a particular asset is going to generate multiple future cash flows, then each of those cash flows has its own present value. When you add up those present values, you get the net present value.