Present Value is “the value today of tomorrow’s cash flows.” A dollar today is worth more than a dollar in the future, because u invest today’s dollar and earn a positive rate of return, a process called compounding. The reverse of compounding is discounting, which converts a future cash flow into its equivalent present value.Specifically, 3 factors govern the present value of any given cash flow : Return, Risk and expected No. of years to achieve the return.

The size of the cash u expect to receive is the “Future Cash Flow.” The larger the future cash flow, the larger the present value.

As uncertainty rises, the investor expecting to receive a future cash flow has to assume more risk–which lowers the value that u should pay today for that future cash flow. “Riskiness” is measured by the rate of return that u would require from an alternative investment that would generate a cash flow with the same level of risk.

The longer u have to wait, the less valuable the cash flow. The length of the wait–the “Number of Years”–lowers the present value of a cash flow for two reasons. First, u could always invest that money in alternative investments that would earn interest during those years. Second, if u’re not confident that u will indeed get that cash flow, the more time passes, the more risk u will have to assume–which lowers the value that someone would pay today for that future cash flow.

The mathematical formula is:

Present Value = Future Cash Flow / (1 + Required Rate of Return) Number of Years U Have To Wait For The Cash Flow

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