1 - The Present Value Concept

Abstract

The main difficulty in comparing present expenditure with future receipts lies in the fact that a sum of money in the hand at present is worth more than the same sum one year hence because interest can be earned on it in the meantime. For example, if £100 is invested today at an interest rate of 10% per annum, in one year's time, it will be worth £110. Therefore, the present value of £110 in one year's time with 10% interest is £100. Similarly, £100 in one year's time with 10% interest has a present value of £90.91. Any sum that occurs in the future can be reduced to its present value if it is divided by the compound interest that £1 could earn, between now and then, at the going rate. The advantage of using the present value concept is that all sums of money that arise at various times in the future can be reduced to equivalent sums of money at today's rate.