Present value calculations are among the most important activities a company can use to assess new projects or business opportunities. The present value of a single sum is typically a future amount of money a business earns from a certain activity that it is not currently engaged in. Factors that can affect the present value of a single sum include the interest rate associated with the money, how many times the interest compounds annually, and the number of years away the money is from being available. Different formulas exist for computing present value sums. Companies must look at their circumstances and data prior to selecting the formula that works best for the situational review.
An interest rate is typically the most important factor that affects the present value of a single sum. This rate indicates the amount of reward a business will receive for investing money into a certain item for financial returns. Another closely related issue at hand with the interest rate is the amount of money that represents the future value. A lower future value with a higher interest rate may be almost as valuable as a higher future money value with a lower interest rate. In either case, the purpose of the present value formula is to discover which factors in the two scenarios will work to the company’s best interest.
Interest in investments or other financial activities may compound more than one time in a year. This can greatly affect the present value of a future sum as more money in terms of interest is expected when interest compounds more times in a year. Another issue at hand is if the interest rate is at least compounding year over year, meaning the investment will grow based on the present value plus previous years’ interest growth. If the investment only carries simple interest, the present value of a single sum will be less than compounding interest as simple interest only computes off of principal and not gained interest. If the latter situation is the case, a different formula is necessary to compute present value.
The numbers of years an investment lasts is another pertinent factor in the computation of present value. As investments stretch to longer periods, the future value of the years furthest away from the current time is less and less. Therefore, the present value of a single sum is greater the more years that are involved in the project, but the monetary growth over these years decreases precipitously.