-a dollar paid in the future is worth less than a dollar today.
-amounts to be received in the future must be discounted by some factor if one wishes to ascertain their present worth.
-the more distant the deferred service, the lower its present price.
P(1) = A / ( 1 + r )
P(t) = (1 + r)^t = A
PV = (5)SUM(t=1): A(t) / [(1+r))^t]
If interest paid more than once a year:
PV = A(t) / [(1+r/m)^(m*t)]
THE NET PRESENT VALUE METHOD
1. Estimate the returns that can be expected to be realized from the investment over time.
2. Discount those projected returns to the present value.
3. Investment is acceptable if present value of estimated returns = or > cash outlay required to finance it.
I.e., new machine costs $18,000.
useful life of machine = 5 years. (value = 0 at end of 5 years).
machine adds $5,600 after taxes to firm’s annual income for 5 year period.
assume 10% discount rate.
PV = $21,224 (3.79 x $5,600)
Net Present Value = Discounted sum of expected inflows minus cost.
($21,224 - $18,000) = $3,224 (NPV)
NPV is positive, so investment is acceptable, outlay should be made.