Present value factor for deal finalization
What is the present value factor?
The Present value factor is a factor which is an indicator of the difference between the present value of the money and the future value of the money. In finance, the present value (PV) of the money received at present is always higher than the value of the money, which is likely to be received in the future.
How to calculate the present value factor?
The PV factor formula is based on the concept that the value of money changes with time. If money is received immediately, it can be reinvested to get better returns. On the other hand, if the money is received later, it can be invested only after the receipt so that the total value will be less.
There is also a risk that the payment will not be received later as promised due to several factors. The PV factor will be higher for cash receipts, which are likely to be received immediately, in one week or one month, compared to payments received after one year or more. The PV factor is always a number less than one. The PV factor depends on the expected return rate (r) on the amount due and the time period (n) after which the payment is likely to be received, usually in years.
The formula for calculating the PV factor is as follows,
PV factor = 1 / (1+r)^n
r varies depending on the expected return on investment. It may be 8% or 10% or lower. The PV factor is useful for businesses receiving offers where payment cannot be made immediately; they will typically make it later, typically after one year or three years or more. The business will have to decide whether it is better to accept the offer for payment a few years later or accept a lower payment, which will be made immediately.
Present value factor calculator
Though the formula for calculating the PV factor is provided above, the PV factor is usually specified in a present value table for business and finance purposes. This table shows how the PV factors will vary over a period of time, as the interest rates vary. In most countries and many businesses, the interest rates are changing periodically depending on several factors. The table will only give the PV factor variation for specific values of interest rate and time periods so that the business can get some idea of how value and interest rates vary,
However, when greater precision is required while finalizing business deals and similar applications, it is advisable to use the table’s formula. For example, the cost of capital for a business is 8%. The business has received an offer to purchase it after one year, pay $100000, or immediately purchase for $95000. The PV factor for the business using the above formula is 0.9259. Hence the present value of the $100,000 offer is $92,590. Since the immediate purchase price offer is higher, the business should accept the offer.
The PV factor becomes irrelevant for making decisions only if the interest rate offered for investing the funds available is zero.