Examples and Computations of Present Value and Net Present Value
Example of a Present Value Method Application:
Let us take a simple example of a present value used in insurance packages:
Assume that you will receive insurance proceeds of $1,000 in 2 years. The interest rate is 7%. The question to be asked is: What is really the value of $1,000 after 2 years?
The formula will be: Present Value = Future Value divided by (1 + I)2
Given: Future Value = $1,000
Constant value = 1
Interest rate = 7%
Substituting them to the formula:
Present Value = $1,000 divided by (1+.07)2
Present Value = $873.44
Explanation: The value of $1,000 is not $1,000 after 2 years but only $873.44. The passage of time is considered in money valuation.
Question: Based on the above case, what is the importance of knowing how much is the present value ($873.44) of the amount you are going to receive after two years ($1,000)?
Answer: Assuming all variables constant, it is important to know how much is the valuation of such a future value ($1,000) after the specified time (2 years at an interest rate of 7%), because in comparing it with other insurance offers, for practical purposes, you will choose an investment which gives bigger present values.
Example of a Net Present Value Method:
To show how a discounted cash flow works in a real estate investment, consider Mr. Sotto who buys a house for $100,000. He expects to sell this house for $150,000 three years later. The question will be: Is it a profitable investment?
If you try to look at the given data, your simple calculation will run this way: $150,000 - $100,000 = $50,000. Mr. Sotto will probably obtain a profit of $50,000 from his investment three years later. If that $50,000 is amortized over the three years, his implied annual return (known as the internal rate of return) would be about 14.5%. Looking at those figures, he might be justified in thinking that the purchase looks like a good idea because 14.5% is quite bigger than the industry trend of 10%, for example.
1.1453 x 100,000 = 150,000 approximately.