Present Value Factor

Definition of present value factor:

Presentvalue factor is a factor used to calculate an estimate of the present value of an amount to be received in a future period.Or we can say that present value factor is an estimate of the present value of future cash flow for a project.

Formula for present value factor

            Present value factor =1/(1+i)t

            where i="interest" rate

                and t="time" periods.

 "i"depends on the person, who is calculationg it. It can be different for the same project also. It depends on the level of risk which a person can take.

Applications of Present Value Factor:

Present value factor is basically used for

1.calculating present value of future cash flows using time value of money

2.calculating present value of annuity.

Themoney is depriciated at a rate , which is called discount rate. Discount rate used is generally the weighted average cost of capital ( WACC) , that reflects two things :

1.The time value of money ( risk free rate) : this represent the preferance of the consumers preferance to have the money now rather thanlater. So the consumer should be compensated for waiting.

2. A risk premium : this repesent the extra return the investors demand , for the risk , they bear that the money may not realize.

Net Present Value:

Net present value indicates the value an investment or a project adds to the firm.

NPV >0The investment is going to be fruitful to the firm.The project should be accepted by the firm.
NPV =0The investment is neutral to the firm. It is not going to add any value or do any harm to the company.Project may be accepted or rejected.
NPV<0The project is going to harm the firm.Project should be rejected.

Limitations of Net Present Value Factor:

1.Thedicounted rate is determined by keeping in mind , the present market situation. The market situation is not static, it is always changing, sothe discounted rate also. So determining the discounted rate is quite hard.

2. Straight line assumption about increasing income, is some time misleading. It does nottake care of the cyclical nature of many market conditions.