The Present Value of an entity can be defined as the present worth of a prospective amount of money or a stream of cash flows with a specified return rate. The Present Value is conversely related to the discount rate. Thus, a higher discount rate implies a lower present value and vice versa. Accurate determination of cash flows is, therefore, the key to appropriately valuing future cash flows, be it earnings or obligations.
The calculation of the Present Value holds extreme importance in different financial calculations like Net Present Value, spot rates, bond yields, and pension obligations. The apposite definition for Present Value (PV) is given as the current value of one or higher future cash payments which are discounted at a reasonable interest rate.
Present Value = Future Cash Flow / (1 + Required Rate of Return)N
N – a number of years you have to wait for the cash flow;
"Required Rate of Return" is named "discount rate".
"(1 + Required Rate of Return)N" is named "discounting factor".
Calculating the Present Value
Generally, there are three factors which influence the calculation of the Present Value:
- The size of the cash flow
The future cash flow implies the size of the cash which is expected to be received. The future cash flow and the present value are related directly. A larger future cash flow implies a higher present value.
- The risk involved in cash flow
With rising uncertainty, the investor anticipating the receipt of a cash flow has to presume higher risk. This presumed level of high risk lowers the value that should be paid at present for the future cash flow. The “risk” involved is calculated by the rate of return which you might require from another investment aimed at generating cash flow with the same risk level.
- The waiting period involved in cash flow
A longer waiting period lowers the value of cash flow. This reduction in the present value of a cash flow is accrued to two reasons –
a. The money which has been invested could be invested in some other project which would earn you interest during the years which you have been waiting.
b. If, in case, you are not sure about getting the expected cash flow , you will have to presume more risk with time passing by thereby lowering the value that would be paid by someone for that future cash flow.