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Discounting and Present Value Analysis

The document discusses the concept of discounting and the time value of money, emphasizing that money received today is more valuable than the same amount received in the future due to risks and opportunities. It explains the discounting process, including a formula for calculating present value based on future cash inflows and a specific numerical example to determine the acceptability of a project based on net present value. The conclusion of the example indicates that the project should be accepted as the present value of cash inflows exceeds the cash outflow.

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Gautam Verma
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16 views8 pages

Discounting and Present Value Analysis

The document discusses the concept of discounting and the time value of money, emphasizing that money received today is more valuable than the same amount received in the future due to risks and opportunities. It explains the discounting process, including a formula for calculating present value based on future cash inflows and a specific numerical example to determine the acceptability of a project based on net present value. The conclusion of the example indicates that the project should be accepted as the present value of cash inflows exceeds the cash outflow.

Uploaded by

Gautam Verma
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© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd

DISCOUNTING

Discounting
• Almost all managerial decisions relate to the future.
• The value of money today is not the same as it will be at a later point
of time.
• Anything that is received later always involves an element of risk.
• A rupee received today is more valuable than a rupee that will be
received later.
• This is known as the time value of money and it arises because of the
following reasons:
Time value of money: Reasons
• Uncertainty of future receipts:
• Urgency of present needs
• Inability to enjoy future consumption
• Investment opportunities
Discounting
• Thus, the money received today is more valuable than that which will be
received later.
• In other words, “the present value of Rs. 100 received at a later date is less
than Rs. 100”.
• This also means that 100 received at a later date would be equal to (100 – x)
received today.
• This ‘x’ is the discounting factor that is incorporated to equate the present
value of money received at two different points of time.
• This ‘x’ accounts for the ‘time value of money’.
• This process of calculating the present value by using mathematical formulae
for adjusting the time value of money is known as ‘discounting’.
Calculation
• If the rate of return is ‘r’ per cent per annum, the present value of an
amount A to be received after ‘n’ years is:
𝑨
•𝑷= 𝒓
(𝟏+ 𝟏𝟎𝟎)𝒏
Numerical Problem
• A project has a cash outflow of Rs. 1,00,000. it yields cash inflows of
Rs. 30,000, Rs. 45,000 and Rs. 55,000 in the first, second and third
years respectively.
• The firm will accept the project if the net present value of cash
inflows is more than that of outflow.
• Should the project be accepted if the cost of capital is 12%?
Solution
Year 0 1,00,000 Cash outflow (𝑪𝟎 )
Year 1 30,000 Cash inflow (𝐶1 )
Year 2 45,000 Cash inflow (𝐶2 )
Year 3 55,000 Cash inflow (𝐶3 )
• Since the cash outflow occurs today (year 0) so its present value (PV) is
same, i.e., Rs. 1,00,000
30,000 30,000
• 𝑃𝑉 𝑜𝑓 𝐶1 = = = Rs. 26786
(1+0.12)1 1.12
45,000 45,000
• 𝑃𝑉 𝑜𝑓 𝐶2 = = = Rs. 35874
(1+0.12)2 (1.12)2
55,000 55,000
• 𝑃𝑉 𝑜𝑓 𝐶3 = = = Rs. 39148
(1+0.12)3 (1.12)3
• Total present values of cash inflows is = 26786 + 35874 + 39148 =
𝑅𝑠. 1,01,718
• Since the present value of cash inflows is more than that of outflow, the
project should be accepted.

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