where P is present worth or present value, F is future value, i is the interest or discount rate, and n is the number of periods. As a simple example, if we have or hold $1,000, in one year at 6 percent interest compounded annually, the $1,000 would have a computed present value of:
Because our money can "work" at 6% interest, there is no difference between $943.40 now and $1,000 in one year because they both have the same value now. Economically, there is an additional factor at work in present value, and that factor is pure time preference, or impatience. However, this issue is generally ignored in business accounting, because the firm has no such emotions, and opportunities can be measured in terms of financial return.
But going back to our $1,000, if the money was received in three years, the present value would be:
P= $1,000/(1 + 0.06)3 = $839.62 In considering either multiple payments or cash into and out of a company, the present values are additive. For example, at 6 percent interest, the present value of receiving both $1,000 in one year and $1,000 in three years would be $943.40 + $839.62 = $1,783.06. Similarly, if one was to receive $1,000 in one year, and pay $1,000 in 3 years the present value would be $943.40 - $839.62 = $103.78. It is common practice to compare investment options based on the present-value equation shown above. We may also apply one or all of the following four factors when comparing investment options: Payback period; Internal rate of return; Benefit-to-cost ratio; and Present value of net benefit.
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