How to Calculate Present Value

Dr. Himanshu Joshi

FORE School of Management
New Delhi
How to Calculate Time Value of
Money
A corporations shareholders want
maximum value. To reach this goal, the
company needs to invest in real assets that
are worth more than they cost.
Here we discuss how assets are valued and
capital investments are made.
The Time Value of Money

Conceptually time value of money means that the value of a unit
of money is different in different time periods.

The value of a sum of money received today is more than its value
received after some time.

Few methods of dealing time value of money are :
- future value of a single amount
- present value of a single amount
- future value of an annuity
- present value of an annuity
- intra-year compounding and discounting

In general, Compounding means calculating future value
of present amount and Discounting means calculating present
value of future amount.
I. Future Value Of A Single Amount

In this case we calculate the future value of a single amount.

The process of investing money as well as reinvesting the interest
earned thereon is called compounding.

The future value or compounded value of an investment after n
years when the interest rate is r percent is

FV
n
= PV (1+r)
n


In this case, the equation (1+r)
n
is called the future value interest
factor (FVIF) or simply the future value factor.

Either you calculate the value of FVIF or there is a table which
gives you the value of FVIF.
Compound and Simple interest :

So far we have assumed that money is invested at compound
interest which means that each interest payment received is
reinvested in future periods.

But in case of simple interest, the investment will grow as

FV
n
= PV [ 1 + No of years Interest rate]


II. Present Value Of A Single Amount

In this case we calculate the present value of future amount.

The present value can be calculated by discounting the amount
to the present point of time.
The process of discounting is simply the inverse of compounding.

The formula for calculating present value is

PV = FV
n
[ 1 / (1+r)
n
]

The factor 1 / (1 + r)
n
is called as the discounting factor or
present value interest factor (PVIF).

There is a table of PVIF which gives the value of PVIF at different
combination of r and n.

Present Value of an Uneven Series :

If cash flow stream is uneven i.e., the same amount of cash is
not flowing every year, then the formula will be different.
The formula for calculating present value of cash flow stream
uneven or even is

PV
n
= . A1 . + . A2 . + . A3 . + . + . An .
(1+r)
1
(1+r)
2
(1+r)
3
(1+r)
n


=

=
+
n
t
r
1
t
t
) 1 (
A
where, PV
n
= present value of cash flow stream
A
t
= cash flow occuring at the end of year t
r = discount rate
n = duration of the cash flow.
Calculating the Present Value of an Investment Opportunity

Suppose you own a small company that is contemplating
construction of an office block. The total cost of buying the
land and constructing the building is Rs. 3,70,000, but your
real estate adviser forecasts a shortage of office space a
year from now and predicts that you will be able to sell the
building for Rs. 4,20,000.
For simplicity, we will assume that this Rs. 4,20,000 is a
sure thing.

You should go ahead with the project if the present value of
future cash inflows is higher than Rs. 3,70,000.

Q. Is this investment really a sure thing?
How to Value Perpetuities

Consols are perpetuities issued by British Government.
These are bonds that the Government is under no obligation to
repay but that offer a fixed income for each year to perpetuity.

The British government still paying interest on Consols issued
all those years ago.

The annual return on a perpetuity is equal to the promised
annual payment divided by the present value:

Return = Cash inflow/Present Value
Or Present Value = Cash inflow/return




III. Future Value Of An Annuity :

An annuity is a stream of cash flow (payment or receipt) occurring
at regular interval of time.

When cash flows occur at the end of each period the annuity is
called an ordinary annuity or a deferred annuity.

When cash flow occur at the beginning each period, the annuity
is called an annuity due.

The formula for calculating the future value of an annuity is

FVA
n
= A [(1+r)
n
1] / r
where FVA
n
= future value of an annuity for duration of n years
A = constant periodic flow
r = interest rate per period
n = duration of the annuity
The term [(1+r)
n
1] / r is referred to as the future value interest
factor for an annuity (FVIFA
r,n
).

Applications :

The future annuity formula can be applied in different cases.


IV. Present Value Of An Annuity :

In this case we calculate the present value of stream of cash
inflows.

The present value of an annuity is actually the sum of the present
value of all the inflows of this annuity.
The formula for calculating the present value of an annuity is

PVA
n
=
n 2
r) (1
A
...
r) (1
A
r) (1
A
+
+ +
+
+
+
PVA
n
= A {[(1+r)
n
1] / r (1+r)
n
}

where PVA
n
= present value of an annuity for n years
A = constant periodic flow
r = discount rate

The factor - [(1+r)
n
1] / r (1+r)
n
is referred as present value
interest factor for an annuity (PVIFA
r,n
).

Present Value of a Growing Annuity :

A cash flow that grows at a rate for a specified period of time is
a growing annuity.

The formula for present value of a growing annuity is

PVGA = A (1+g)
(
(
(
(

+
+

g - r
r) (1
) g 1 (
1
n
n
The above formula can be used when the growth rate is either
less than or more than discount rate (g<r or g>r).

However it does not work when growth rate and discount rate are
equal. In this case, the present value is simply equal to n A.
Annuities Due :

When cash flow occur at the beginning of each period, such an
annuity is called as annuity due.

Since the cash flows of an annuity due occur one period earlier
in comparison to the cash flows of an ordinary annuity, the
formula for annuity due will be

Annuity due value = Ordinary annuity value (1+r)

Present Value of a Perpetuity :

A perpetuity is an annuity of infinite duration. It may be expressed
as
P

= A PVIFA
r,
where P

= present value of a perpetuity

A = constant annual payment
and PVIFA
r,
= present value interest factor for a perpetuity


and PVIFA
r,
=
r
1
) r 1 (
1
1
=
+

=
o
t

Thus it means that the present value interest factor of a perpetuity
is simply 1 divided by the interest rate expressed in decimal form.

Intra-Year Compounding And Discounting :

Here we will discuss the case where compounding / discounting
is done more frequently, i.e., more than once a year (like
semi-annually, quarterly, monthly etc)
The general formula for the future value of a single cash flow
after n years when compounding is done m times a year

FV
n
= PV
n m
(

+
m
r
1
If compounding is done more than once a year, effective interest
rate will be different than stated interest rate.

The general relationship between the effective interest rate and
the stated annual interest rate is as follows

Effective interest rate =
1
m
rate interest annual Stated
1
(

+
m
where m is the frequency of compounding per year.
Sometimes cash flows have to be discounted more frequently than
once a year.

The general formula for calculating the present value in the case of
shorter discounting period is

PV = FV
n

n m
(
(

+
m
r
1
1
where PV = present value
FVn = cash flow after n years
m = number of times per year discounting is done
r=annual discount rate
When compounding becomes continuous, the effective interest is
expressed as
e
r
1,
where e = base of natural logarithm and r = stated interest rate.