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I apologize for not understanding this question even after watching your lecture on discounted cashflows and interest as you said earlier… Could you please help me clarifying the reasoning behind it?
What is the point or reason behind calculating the Present value of future income or liability as of today?
For example if we have a future income of $100,000 because we have made an investment at a interest rate of 10% for 2 years then its present value would be $82,645 then what does it prove?
Similarly if we have a future liability of $120,000 because we have borrowed money at a interest of 12% for 5 years then its present value would be $68,091 then again what does it prove except that if we pay the loan today then we have to pay smaller amount than latter.
Thanks so much…
Neither of them actually prove anything.
However in the first case getting $100,000 in 2 years time would be exactly the same as receiving $82,645 now (because if we did receive $82,645 now then we could invest it at 10% and then get $100,000 in 2 years time).
The reason it is useful is suppose I had the choice between one investment that gave me $100,000 in 2 years time, and another investment giving $120,000 in 4 years time. They are not directly comparable (because for the second we have to wait an extra 2 years). By calculating the PV in each case (which is effectively ‘removing’ the interest) we can compare directly – the one with the higher present value is the better one.
Another reason that it is useful is that suppose in the first case there was an investment that required me to spend $80,000 now and gave a return of $100,000 in 2 years time. Although there is a gain of $20,000 we need to take into account that there would be interest for 2 years (either because we had to borrow the $80,000 and therefore pay interest, or even if we had $80,000 spare cash we would be losing interest because we could have put it on deposit and earned interest).
However, since receiving $100,000 in 2 years time is equivalent to getting $82,645 now (after accounting of for the interest) we can now check whether it is worthwhile. Here is is worth paying $80,000 and getting back the equivalent of $82,645 (so a net present value of $2,645). Had we needed to have invested $90,000 then it would not have been worthwhile investing.I understand your point. Thank you. But i have something else to ASK.
The reason for using the PV is to calculate the current value of future cashflows (like future income or future liability) as of today.
In case of investment investors use PV to see how much the future income is worth at present so they can decide whether to invest or not.
In case of borrowing investors use PV to see how much the future liability is worth at present so they can decide whether to borrow or not.
In other words investors evaluate the PV of various borrowing options to see whatever loan is cheaper to borrow.
For example we have two borrowing scenarios:
1) Borrow $120,000 at interest rate of 12% for 5 years.2) Borrow $120,000 at interest rate of 10% for 5 years.
PV = $68,091
PV = $74,510Investor will choose to borrow the option#1 because it has lower value making it cheaper to borrow as compared to the other.
Is that all CORRECT?
No that is certainly not correct!!!
How on earth could it be better to pay 12% interest than to pay 10% interest?!!!!
The PV’s would only be as you have stated if the cash flow was in 5 years time. That is not the case – they are borrowing money now and so the cash flow is now.
(And borrowing decisions are not relevant until Paper FM anyway)
Which ACCA exam are you studying for, and have you actually watched all of our free lectures?
I passed my exam paper MA last month and now i am studying paper FM (F9) and I am so confused!!!
That’s why i asked you the examples for both investment and borrowing cases where investors can use present value method to evaluate the future cashflows (income in terms of investment and liability in terms of borrowing) to their current value as of today.
Can you please give me examples for both borrowing and investment where we can use present value method?
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