The present value (PV) factor is used to derive the present value of a receipt of cash on a future date. The concept of the present value factor is based on the time value of money - that is, money received now is worth more than money received in the future, since money received now can be reinvested in an alternative investment to earn additional cash.
The PV factor is greater for cash receipts scheduled for the near future, and smaller for receipts that are not expected until a later date. The factor is always a number less than one.
The formula for calculating the present value factor is:
P = (1 / (1 + r)n)
P = The present value factor
r = The interest rate
n = The number of periods over which payments are made
For example, ABC International has received an offer to be paid $100,000 in one year, or $95,000 now. ABC's cost of capital is 8%. When the 8% interest rate is factored into the present value equation, the present value factor is 0.9259. When the present value factor is multiplied by the $100,000 to be paid in one year, it equates to being paid $92,590 right now. Since the offer of being paid $95,000 is greater than the present value to ABC of the later payment, ABC should accept the immediate payment of $95,000.
The present value factor is typically stated in a present value table that shows a number of present value factors in relation to a grid of interest rates and time periods. For a greater degree of precision for values between those stated in such a table, use the formula shown above within an electronic spreadsheet.
The only situation in which the present value factor does not apply is when the interest rate at which funds could otherwise be invested is zero.