Present value is expected value, as of the date of valuation, resulting from discounting future amounts. Present value (PV) can be expressed by the formula PV= ∑ {Period Cash Flow / (1+i)^n}, where “i” represents the interest rate and “n” represents the number of time periods. Present value differs from net present value (NPV) in that NPV accounts for the initial investment outlay, whereas PV does not. Present value is a time value of money concept, frequently utilized in investment decisions. The PV concept can be particularly useful in when comparing investment opportunities with different holding periods or expected cash flow streams.
For example, if investment A is expected to generate even cash flows of $50,000 for 3 years while investment B is expected to produce cash flows over a five year period of $5,000, $10,000, $25,000, $12,000 and $150,000. If the investor applies a 12.0% discount rate, investment A yields a present value of $120,092 (($50,000/(1+.12)^1)+($50,000/(1+.12)^2)+($50,000/(1+..12)^3), while investment B has a present value of $122,971 (($5,000/(1+.12)^1)+($10,000/(1+.12)^2)+($25,000/(1+.08)^3)+($12,000/(1+.12)^4)+($150,000/(1+.12)^5). Notice that investment option B is expected to generate nearly 35% more in total dollars than investment A ($202,000 to $150,000), yet the PV difference is only 2.4% ($122,971 compared to $120,092). This is due to the time value of money concept. Also note that the result is impacted by the choice of discount rate. Had a higher discount rate been applied, investment A would likely yield the higher present value as the majority of investment B’s return occur later in its holding period.
