Salient Points
Future cash flows cannot be compared with related investments at present because they do not happen at the same time. Amounts received or paid in the future are less in value today because of the time value of money. Discounting future cash flows allows comparison at present helping decisions that involve choosing among alternative courses of action. In accounting, discounted cash flow techniques are used in measurement bases that result in relevance and faithful representation of information.
The components of interest are principal, rate, and time. Because of the time value of money, money received in the future is worth less today if money available today is idle. However, future money may be better than today’s money because the opportunities available between now and then may yield more in the future. Present value calculation determines if future money has the same or more value if received today.
Bringing two values to the same moment in time makes comparison possible. Common comparisons include that between cost and benefits. Investing and financing decisions always involve both a present and future cash flow. Comparing face values is not proper because of the time value of money. Future cash flows must be brought to the present. Comparing current cash outflow with the present value of future cash flows, results in a net present value, useful in making a choice among several alternatives. Because the present value is less than future value, the process of determining present value is also known as discounted cash flow calculation.
Future cash flows depend on the nature of the project or initial investment and vary in timing and amount. Some amounts are received in uniform equal streams, others are received or paid in lump-sum amounts at the end of specific period, while other cash flows involve unequal amounts. A cash flow stream of equal amounts over a period is known as an annuity, common in loan amortizations, bonds, and leases. There are two types of annuity, ordinary annuity, and annuity due. In an ordinary annuity cash is received or paid at the end of the period. In annuity due cash is received or paid at the beginning of the period. This timing difference results in different present values.
Ensuring the reasonableness and certainty of the variables require careful study and evaluation. Any serious distortion or inaccuracy will result in unreliable present value information. Calculating present values is the easy part, with several tools available starting with the present value formulas, which are based on the components and mechanics of simple interest calculation. Present value tables are found in most finance and accounting textbooks.
Computer software and spreadsheet programs facilitate present value calculation with speed and accuracy. The financial calculator also provides the same functionalities for the computation of present values. Because formulas are easily forgotten, and present value tables and computers may not always be available, the financial calculator is the most handy and convenient tool favored by business professionals and students.
Present value calculation is used in many business decisions involving substantial cash flow to be made at present. Capital investment decisions involve present value calculation as a major feature in the evaluation of project proposals, like expansion or replacement of facilities, make-or-buy, and lease-or-purchase decisions. Investors in bonds use present value calculations to determine purchase price of bonds. In accounting, some items in the financial statements are measured using present value information to conform with standards of measurement and ensure relevance and faithful representation of information. Notable applications include value in use, lease payments, and bond amortization.
