Future Value (FV) and Present Value (PV)

To learn DCF (Discounted Cash Flow), we need to first learn about the time
value of money. The value of $ 10000 now, will not be the same, N years hence.
Similarly, the value of $ 10000 received N years hence will not be the same had
it been received now considering the time value of money. We need to learn
about the future value and present value of money.

Future Value: If you have $ 10000 today and the interest applicable on

investment is 5% per year, then the future value of $ 10000, a year hence

= 10000 X (1+5/100) = $ 10500

The future value of $ 10500 a year hence will be = 10500 X (1+5/100) = $ 11025

If you have $ 10000 today and the interest applicable on investment is 5% per

year, then the future value of $ 10000, two years hence = 10000 X (1+5/100)2 = $

11025

Present Value: From the above, we can also conclude that the present value of $

11025 received two year hence = $ 11025/ ([1+5/100]2) = $ 10000

So if you receive $ 11025 two years hence, it is equivalent to receiving $ 10000

now.

So if you receive $ X, after Y years from now, and the interest rate is ‘i’, the

present value of $ X can be calculated as = $ X / ([1 + i/100]Y)

Discounted Cash Flow – a tool to compare the investment options

Evaluating the investment in projects A and B using DCF (Discounted cash flow)

Let us consider two projects A and B of similar risk. Let us also assume an interest

rate (discounting rate) of 5%. Now let us evaluate the two projects A and B based

on the timing of cash inflows and outflows. For this, we need to compute the PV

(Present value) of the inflows and outflows and determine the Net Present Value

(NPV) of the two projects. In Table -1 below, we see that for the two projects, the

total outflow and inflow are the same. The net inflow is also the same for the two

projects. In Table – 2, the PV (Present value) for all cash flows are determined

taking into account the time value of money.

We can see that the NPV is higher for Project A as compared to Project B .

Therefore Project A is a better investment option.

 Table - 1
PROJECT A PROJECT B
Year INFLOW OUTFLOW INFLOW OUTFLOW
0 100000 75000
1 50000 75000
2 20000 50000 20000 50000
3 60000 60000 10000
4 70000 20000 10000
5 80000 70000
6 50000 130000
7 60000 60000
Total 340000 220000 340000 220000
NET INFLOW 120000 120000

Interest 5%
Table - 2
PROJECT A PROJECT B
PV PV PV PV
Year INFLOW OUTFLOW INFLOW OUTFLOW
0 100000 75000
1 47619 71429
2 18141 45351 18141 45351
3 51830 51830 8638
4 57589 16454 8227
5 62682 54847
6 37311 97008
7 42641 42641
Total 270194 209425 264467 208645
NET INFLOW 60769 55821

The NPV is 60769 for Project A which is greater than that for Project B which is

55821. So project A is a better option.

Internal rate of return (IRR) – another tool to compare investment options

IRR is the discounting rate ‘i’ such that the total PV of cash inflows = total PV of

cash outflows.

The value of ‘i’ the discounting rate (interest rate) is changed to make the total PV

of cash outflows = the total PV of cash inflows. In other words, the value of

discounting rate ‘i’ is determined so as to make NPV = 0. In the below Table, the

IRR for Project A and B are determined.

It can be seen that for Project A, when i = 12.59%, the total PV of cash inflows is

almost equal to the total PV of cash outflows. It can also be seen that for Project

B, when i = 11.43%, the total PV of cash inflows is almost equal to the total PV of

cash outflows. So the IRR of Projects A and B are respectively 12.59% and

11.43%. So Project A is a better option than Project B as Project A has a higher

IRR.