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Monday, January 21, 2013

Using present value when evaluating investment options

Present value calculation
Present value calculation is used to assess stock option worth
By Donald Turner

“A bird in the hand is worth two in the bush.” While this phrase was first used in mediaeval times, the person who said it must have had some idea about present value. In a sense, present value answers the question about how money in the future is worth today. Most people understand intuitively that $10 today is more valuable than $10 a year from now. Furthermore, if you have the option of $10 today, $11 a year from now, or $15 three years from now, which one would be the best option? This article will show you how to make that decision.

Comparing apples to apples

The problem is that the amounts of money really can’t be compared. To change the example, suppose you had the option of receiving $10, 50 yen, or 50 rupees. Which would you choose? You would not look at the raw numbers, because they’re for different currencies. First, get them into a common currency, and then see which one is the largest amount. In this case, 50 yen is less than $1, and 50 rupees is about $1. Choosing $10 would make the most sense.

It is the same problem in choosing among the different options in our earlier example. Present Value (PV) is the term that is used to take money paid at different times and converting them to a common basis for comparison in today's dollars, similar to the currency example.

Discount rate

The place to begin the conversion process is with figuring out the discount rate. The discount rate is the interest rate that you would expect for an investment. It is important to determine a good value for the discount rate, as it becomes the basis for converting the future cash payments to a value today. Selecting the discount rate can be done in several ways. For example, a business may use a discount rate that is the minimum return they would expect from any investment. Individuals might choose a discount rate that reflects their desired investment return. In either case, selecting a discount rate that is either too high or too low will improperly skew the results, so choose carefully.

Determining present value

Let’s choose 10 percent as the discount rate for answering the question which of the three options in the earlier example is the best. The baseline is $10, since that is the amount available today. For the future values for this example, the rate is only applied once per year, so $11 one year now can be discounted by dividing the future amount by 1 plus the discount rate. In this situation, the present value equals $11/(1 + .1) or $10. So, $11 one year from now is equal to $10 today at a 10 percent discount rate.

What about $15 three years from now? The present value calculation would be similar, except the above formula would have to be applied three times, once for each period. Since this can become very tedious, most financial calculators and spreadsheet software packages have this calculation built in. Using this formula, $15 three years from now is worth $11.28 today.

Putting it all together

Using this approach, it’s clear which option to choose. The third option, $15 three years from now would be the best option. You can use this approach to evaluate any kind of investment where payments occur at different times.

About the author: This article was written by Donald Turner, an avid finance writer online, on behalf of Approved Cash Advance. If you're looking for an InheritedCash Advance, make sure to check out their website and see what they can do for you.

Image license: FamZoo Staff, CC BY-SA 2.0