Cash flow is extremely important to your business. Having healthy reserves of cash enables you to maintain operating cash flow and pay for capital expenditures without relying on borrowing. But the cash reserves in your business bank account now will not retain the same value in the years to come. A thousand dollars will be worth more now than in five years’ time, unless it is invested in a facility that will secure it a rate of interest. This is why it’s so important to account for the present value (PV) of your cash now in contrast to its value years down the line.
Comprehensive financial forecasting means accounting for the value of future revenue streams and cash flows. It means accounting for interest rates and the rate of inflation and their impact on purchasing power in the future. Net present value (NPV) is the difference between the present value of your cash inflows and outflows over a given time period. An internal rate of return (or yield) is an interest rate at which the NPV is equal to zero.
How to calculate present value
To find the present value of assets like cash, you must first ascertain the discount rate. This is the discounted rate of return applied to the PV calculation. It is the foregone rate that would need to be applied by an investor for them to accept a given monetary figure in the future as opposed to the same figure today. As such, these are highly subjective. The term ‘discount’ is applied because future value is discounted from present value.
To put it another way, the discount rate is a combination of the time value and a relevant interest rate that would increase future value. Conversely, the discount rate can also be used to work out future value (FV) in relation to present value. This is useful for lenders as it allows them to settle on a fair amount for any future earnings or obligations in relation to the capital’s present value.
The calculation for PV is as follows:
start with the future amount that you expect to receive
calculate the interest rate that you expect to receive
establish a time period to use as an exponent
In other words, present value = FV÷ (1 + rate of return) X time period.
To calculate net profit value (NPV), on the other hand, you must estimate future cash flows for each period and ascertain the correct discount rate.
Present value vs future value
To understand the time value of money, it’s important to understand the relationship between PV and future value. Future value (FV) is the value of a current asset a projected future date, based on a predicted rate of growth.
Present value, on the other hand, refers to the current value of a future cash sum or cash flow stream with an assumed rate of return.
Frequently asked questions about present value
Why is present value important?
Understanding present value is essential to judging whether you’re paying the right price for a potential investment. For instance, if you had a choice of earning a fixed sum for the investment in a year’s time, or gaining a percentage of the principal, knowing PV and FV calculations can help you to make the better call.
An understanding of PV and FV is also useful outside of business. For instance, understanding the present and future values of an annuity can help you to better forecast your retirement income.
Is present value reliable?
Present value is as reliable as the predicted rate of return used in the calculation. These are highly subjective, and predictions can be rendered inaccurate by unexpected rises in the rate of inflation. Inflation hikes may erode the expected return on a given investment.