Present value (or present dollars) is the current worth of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows.
For example, an investment of $1,000 today at 10 percent will yield $1,100 at the end of the year; therefore, the present value of $1,100 at the desired rate of return (10 percent) is $1,000.
Net present value is used in capital budgeting to analyze the profitability of an investment or project, and is a measure of the net benefit of a project in today’s dollar terms. Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they be earnings or obligations.
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