A bird in hand is worth two in the bush. This prose is true whenever you consider any investment, which encourages you to calculate time value money for an investment. Time value money is a concept that mentions that it is more important to receive an amount today that receiving the same amount a year down the line. For example, it is more valuable to receive $ 1000 today than receiving the $ 1000 a year or two down the line.
The present value of $ 1000 that you receive after a year is less than $ 1000. This is because the $ 1000 that you will receive includes the interest accrued over the year. Therefor, according to the time value money, the present value of this amount would be $ 1000 actually be $ 1000 – the interest amount. If you take 10% as the prevailing interest rate, the present value of this amount would be $ 1000 – $ 100, which amounts to $ 900. Therefore, notice that the calculation of the present value removes the interest part.
When calculating the present value, you compound the interest. The interest accrued for a time period is added to the principal amount before interest for the next time period is calculated.
Calculating the present value of the makes an important check when selecting a project. In this economic model, you evaluate the current value of the future cash flow of the project. To calculate the current value of the future cash flow, you can use the following formula:
PV = FV / (1 + r)n
In this formula:
- PV is the present value of the amount
- FV is the future value of the amount
- r is the rate of interest used to discount the future value of the amount
- n is the number of time periods after which the future value is received
For example, for a project that you expect to receive revenue of $ 500,000 after five years with prevailing interest rate as 10%, then you can calculate the present value of the amount as follows:
- PV is to be determined
- FV = $ 50,000
- r = 10% or 0.1
- n = 5
Therefore, in this case:
PV = 500,000 / (1 + 0.1)5
= 500,000 / 1.61
You can notice that the present value of the $ 500,000 revenue you will receive after five years is 310,559.
If you expect more than one future values form the project, as expected in a real life project, you can calculate the present value of all of these future values individually, and then add all the present values to get a single present value for the project.
You can calculate the present value of all the candidate projects and select the one that provides you the highest present value for the amount invested in the project.