PRESENT VALUE CALCULATION 4

PresentValue Calculation

Supposeyour bank account will be worth $4,200.00 in one year. The interestrate (discount rate) that the bank pays is 5%. What is the presentvalue of your bank account today?

PV=PV1 x 1.05=$4,200

PV1=$4,200/1.05

=$4,000

ThePresent value of the bank value today is $4,000

Supposeyou have two bank accounts, one called Account A and another AccountB. Account A will be worth $3,800.00 in one year. Account B will beworth $6,500.00 in two years. Both accounts earn 5% interest. What isthe present value of each of these accounts? What is the combinedpresent value of the two accounts?

PVaccount A= $3800/1.05

=$3,619.05

PVaccount B= PV_{B}Year2= $6,500/1.05

=$6,190.48

PV_{B}Year 1= $6,190.48/1.05

AccountB PV =$5,895.7

CombinedPresent Value= $3,619.05+$5,895.70

=$9,514.75

Supposeyou just inherited an oil well. This oil well is believed to havethree years worth of oil left before it dries up. Here is how muchincome this oil well is projected to bring you each year for the nextthree years:Year 1: $125,000 Year 2: $258,000Year 3:$310,000Compute the present value of this stream ofincome using a discount rate of 7%. Remember, you are calculating thepresent value for a whole stream of income, i.e. the total value ofreceiving all three payments (how much you would pay right now toreceive these three payments in the future). Your answer should beone number – the present value for this oil well at a 7% discountrate.

PV_{1}=$125,000/1.07

=$116,822.43

PV_{2}=$258,000/1.07^{2}

=$225,347.19

PV_{3}=$310,000/1.07^{3}

=$253,052.34

Presentvalue for the oil well at a 7% discount rate is = $595,221.96

Presentvalue can be used when managers want to find out the projects thatare worth more than their cost. Projects whose net present value ispositive should be accepted more so when there are no budgetconstraints.

Inthe third example, it can be noted that present value can be used torate the profitability of investment projects. Forinstance, the decision-making criterion is: invest in projects whosepresent value of the flow of income generated is more than the sumthat is enough to invest in the projects. When money is limited,choose the most profitable projects.

References

Portney,Paul R. (2012). Benefit-Cost Analysis. The Concise Encyclopedia ofEconomics.

[AvailableOnline] http://www.econlib.org/LIBRARY/Enc/BenefitCostAnalysis.html.