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When we solve for the present value, instead of compounding the cash flows to the future, we discount the future cash flows to the present value to match with the investments that we are making today. Bringing the values to present serves two purposes:

1.                  The comparison between the projects become easier as the values of returns of both are as of today, and

2.                  We can compare the earnings from the future with the investment we are making today to get an idea of whether we are making any profit from the investment or not.

 

For calculating the present value we need two things, one, the discount rate (or the opportunity cost of capital) and two, the formula.

 

The present value of a lump sum is just the reverse of the formula of the compound value of the lump sum:

                                                 

Or to use the tables the change would be:

Present Value = Future Value * (Present Value Interest Factor_n,i)

where n = no of time periods and i is the interest rate.

Let us look at an example of how we calculate the present value: