Present value

Present value is the current worth of cash to be received in the future with one or more payments, which has been discounted at a market rate of interest. The present value of future cash flows is always less than the same amount of future cash flows, since you can immediately invest cash received now, thereby achieving a greater return than from a promise to receive cash in the future.

The concept of present value is critical in many financial applications, such as the valuation of pension obligations, decisions to invest in fixed assets, and whether to purchase one type of investment over another. In the latter case, present value provides a common basis for comparing different types of investments.

An essential component of the present value calculation is the interest rate to use for discounting purposes. While the market rate of interest is the most theoretically correct, it can also be adjusted up or down to account for the perceived risk of the underlying cash flows. For example, if cash flows were perceived to be highly problematic, a higher discount rate might be justified, which would result in a smaller present value.

The concept of present value is especially important in hyperinflationary economies, where the value of money is declining so rapidly that future cash flows have essentially no value at all. The use of present value clarifies this effect.

Related Courses

Excel Formulas and Functions
Financial Analysis 
Introduction to Excel