Chapter 3 part 2

 

The process of finding present value is known as discounting The process of finding present value is known as discounting.(It is the inverse of compounding). The rate of return used to discount is often referred to as discount rate, opportunity cost required return, and the cost of capital. The present value calculation can be simplified by using a present value interest factor. This factor is the multiplier used to calculate , at a specified discount rate, the present value of an amount to be received in a future period.

Present value computation Example-1 Find the present value of OMR 500 due in 1 year at a discount rate of 6 percent. Solution: Here the future value (FV) = OMR 500 Interest rate (i) = 6 % No. of years (n) = 1

The equation for present value PV is : PV = FVn (1+i)n = 500 / (1+0 The equation for present value PV is : PV = FVn (1+i)n = 500 / (1+0.06)1 = 500 / 1.06 = OMR 471.70

Example-2 Find the present value of OMR 500 due in 2 year at a discount rate of 6 percent. Solution: Here the future value (FV) = OMR 500 Interest rate (i) = 6 % No. of years (n) = 2

The equation for present value PV is : PV = FVn (1+i)n = 500 / (1+0.06)2 = 500 / 1.1236 = OMR 445

Example-3 What is the present value of a security that promises to pay you OMR 5,000 in 5 years? Assume that you can earn 7 percent if you were to invest in other securities of equal risk?

Future value (FV) = OMR 5,000 Interest (i) = 7 % = 0.07 No. of years (n) = 5 years The equation for present value PV is : PV = FVn (1+i)n = 5000 / (1+0.07)5 = 5000/(1.07) 5 = 5000 / 1.402 = OMR 3, 566

COMPUTATIONAL TOOLS Time consuming calculations are often involved in finding future and present values. Following are the computation tools used for finding future value and present value of an investment:

Computational Tools Use the Equations Use the Financial Tables Use Financial Calculators Use Electronic Spreadsheets Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

SPREAD SHEETS Like financial calculators, electronic spreadsheets have built in routines that simplify time value calculations. We provide in the text a number of spreadsheet solutions that identify the cell entries for calculating time values. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.

Advantages Electronic Spreadsheets Spreadsheets go far beyond the computational abilities of calculators. Spreadsheets have the ability to program logical decisions. Spreadsheets display not only the calculated values of solutions but also the input conditions on which solutions are based. Spreadsheets encourage teamwork. Spreadsheets enhance learning. Spreadsheets communicate as well as calculate. Copyright © 2006 Pearson Addison-Wesley. All rights reserved.