Present value, how to use and understand it
Present value can be described as concept that is utilised by financial advisors analyzing deals from leases to commodity purchases and mergers and acquisitions. Present value explains the relation of a single dollar today compared to 1 dollar tomorrow.
Example: Anrult Dermenage is selling a piece of real estate in Redwood City. Last night, he was offered USD 10, 000 for the property . Today, another buyer offered him $ 11, 424, however, the second offer is paid one year from today. Anrult has satisfied himself that both offerors are honest and financially solvent. He and his home broker believe that none of the offers will fall through or experience payment troubles . Which of the two offers should Anrult take ?
The answer depends on what Anrult will do with the cash he receives at this moment. If he has a way to
invest the money safely in a bank account and acquire 12 % interest, in one year he will get $ 11, 200:
$ 10, 000 [return of principal] + (0. 12 * $ 10, 000 [interest he is going to get])= $ 11,200. Because this is less than the $ 11, 424 he will receive from his 2nd buyer, Anrult should accept the other offer.
Another way of figuring out this result uses the idea of present value. Present value tells us how much money must Anrult put in the bank today so that he will have $ 11, 424 next year? We can write this as
Present value * 1. 12 = USD 11, 424. Solving for Present value we find
PV = $ 11, 424/1. 12 which equals $ 10, 200. Commonly, the formula for the present value of an one period investment is normally written as:
PV = C1/(1 + r). Prior to deciding to despair about all the funny symbols, here the explanation: C1 is the cash flow at date 1 and r will be the appropriate interest rate, sometimes called the discount rate.
Present value analysis tells us a payment of $ 11, 424 received next year provides a present value today of $ 10, 200. This means that Anrult does not care whether you give him 10,200 today or 11, 424 next year, assuming a 12 % interest rate.
Because the second offer provides a present value of $ 10, 200 and the first offer has a present value of $ 10, 000, Anrult should accept the 2nd offer.
Both future value analysis and present value analysis result in the same decision.
This is a simple but powerful example. Financial analysts, real estate agents , accountants, all employ the present value and future value calculations all the time and of the various financial formulas, ratios, software and other tools, this one is the most widely used and reliable. In an attempt to return to the basics, this can be a tool you should master.
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