Page 42 - DMGT409Basic Financial Management

Unit 3: Time Value of Money

3.4 Discounting or Present Value Concept Notes

The concept of present value is the exact opposite of that of a sum of money or series of payments,
while in case of present value concept, we estimate the present worth or a future payment/
instalment or series of payment adjusted for the time value of money.

The basis of present value approach is that, the opportunity cost exist for money lying idle. That
is to say, that interest can be earned on the money. This return is termed as ‘discounting rate’.

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Caution Given a positive rate of interest, the present value of the future Rupee will always
be lower. The technique for finding the present value is termed as ‘discounting’.

Present value after ‘n’ Years:

Formula:

A
PV =
(1 i+ ) n
Where,
PV = principal amount the investor is willing to forego at present
I = Interest rate.

A = amount at the end of the period ‘n’.
N = Number of years.
With this formula, we can directly calculate the amount; any depositor would be willing to

sacrifice at present, with a time preference rate or discount rate of x%.
Example: If Mr. X, depositor, expects to get ` 100 after one year, at the rate of 10%, the
amount he will have to forego at present can be calculated as follows:
A
PV =
(1 i+ ) n
100
PV = = R s . 90.90
( +1.10 )
Similarly, the present value of an amount of inflow at the end of ‘n’ years can be computed.

Present Value of a Series of Cash Flows

In a business situation, it is very natural that returns received by a firm are spread over a number
of years. An investment made now may fetch returns a certain time period. Every businessman
will like to know whether it is worthwhile to invest or forego a certain sum now, in anticipating
of returns he expects to earn over a number of years. In order to take this decision he needs
to equate the total anticipated future returns, to the present sum he is going to sacrifi ce. The
estimate of the present value of future series of returns, the present value of each expected infl ow
will be calculated.

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