Present value definition
/What is 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.
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.
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How Present Value is Used
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. 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.
Problems with Present Value
Present values can be altered to arrive at a desired number merely by altering the discount rate or the projections of inbound or outbound cash flows. For example, a manager could use either option to arrive at a present value figure that justifies the purchase of an expensive asset - even though actual cash flows do not support this purchase decision.