Present Value (PV) Vs. Future Value (FV) - Paper Example

Both of the two terms (present and future values) are often used in the modern financial world to understand the concept of the net worth of money, that people use. In a broad view, the two terms originate from the idea of time value (TV), and the specific monetary concept gained from them, may be utilized by business owners and entrepreneurs to make daily investment decisions. The primary philosophy here is that the sum of money that one receives today must be more than the amount that would be received in the future. Notably, it is vital to consider the TV of money, to help investors make accurate decisions, by comparing the average cost of investment and possible returns at different timings.

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Present Value

Present value usually defines the current worth of the future summation of money. The concept is part of the necessary financial frameworks, such as bond pricing and stock pricing. Obtaining PV helps one to determine the average sum of money that should be invested today to expect a specific amount in future time. PV can also be referred to as a discounted value. In other words, investors use this as an indicator that, if he/she receives a given sum of funds today, then there are chances of getting a return in the future. In convention, method investors use the following formula to determine the PV, PV = CF/ (1+r) n. “CF” denotes the estimated cash flow in the firm, “r” is the average rate of discounted return, and “n” represented period.

Example

If John promises his son that he will give him a total of $5,000 in four years-time at the rate of 5%. We can find the present value of the promised $5,000 that will be received in four years. PV= 5,000/ (1+0.05) 4 = $4, 113.53. So, this is the present value.

Future Value

Future value (FV) usually represents the sum of money that will grow after a specific period via a simple or compounded type of interest rate. Similar to PV, it also an essential concept of finance, as it involves TV. Typically, it helps an investor to predict the future value of money, based on the projected growth rate after making an investment decision. Method investors calculate it using this formula, FV = PV (1+r) n. Again, "PV" shows the present value, "r" is the expected rate of return, while the "n" is period.

Example

If John wants to invest $5,000 in business, for one year, and the estimated interest rate in 5%, FV will be: FV= 5000 (1+ 0.05) 1= 5, 250. So, the interest of $250 shall be earned after the one year, and the FV will be $5, 250. Compound interest formula can also be used if the period in more than one year.

Operating Cash Flow (OCF)

Operating Cash Flow (OCF) can be defined as the total amount of money that is obtained from the running business practices in a particular period. To determine the sum of generated funds, its calculations are usually started by using the net income from the income statement, adding all items whose values are in non-cash form, and making necessary adjustments in the basic net working capital. During the process of financial analysis, OCF is used concurrently used with net income, and Free Cash Flow (FCF) to assist in the evaluation of the company's performance. OCF net income + Expenses (non-cash) + Increases in the working capital (WC).

The 2017 financial report analysis of Amazon is a typical example of how OCF can be calculated in an organization (Corporate Finance Institute, 2019).

The above (OCF) is organized in three sections; namely, operating activities, investment activities, and the third one are financial operations. In the statement, a starting balance of cash is given the sum of change for a particular period, and the final balance is also shown. To analyze the OCF above, the operating activities include: First, the average net income that is derived from the bottom of the income statement is utilized to act as the starting point.

Secondly, all the non-cash activities, such as the accruals, are added back. Examples of non-cash items are depreciation, stock-based compensation, and the average amount of deferred taxes. For depreciation, the accounting method is meant for expensing properties, plants, and other different equipment purchases. However, the stock-based compensations usually do not get paid out using actual cash, but rather by using issuance shares of shares.

Thirdly, the changes in the working capital are adjusted accordingly. For instance, the inventory that is available in the balance sheet rises, and this leads to a considerable reduction in the total amount of cash. The account receivable is also increased, and again, the cash is reduced concurrently. Accounts receivable refers to a section of revenues that have been recorded, yet the customers have not made payments for them. Lastly, an increase in the sum of accounts payable, total accrued expenditures, and the total unearned revenues, leads to a corresponding increase in cash. In general, the following is an expounded formula for OCF.

OCF= net incomes + total depreciation value + average stocked-based compensations + deferred taxes + any other non-cash items – increases in the account receivable – rise in the inventories + rise in the sum of account payable + increases of total accrued expense + increases in the deferred revenues.

Required Return (RoR)

Required return or required rate of return is defined as the least amount of acceptable return that investors, individuals, or companies can expect after making an investment decision.

All over the world, investors utilize calculated RoR to figure out the minimum rates of return that they should expect, especially after taking consideration of all the options. During the process of making these calculations, investors consider the projected market returns, the nature and value of risk-free RoR, the volatilities of available stock, and also estimated project cost. In convention, the RoR can help to adjust the various types of investments. Therefore, it means that an investor who expects a higher RoR would automatically engage in riskier investment decisions.

Various professionals in the finance sector often determine the RoR to aid them in making decisions of whether to purchase a product or not, while making product rollouts, and before making approvals for any possible mergers. For instance, if an investor is currently engaging in a business that yields an approximately 5% RoR, then he/ she would seemingly take another investment opportunity if the RoR for that deal is 6% and above. RoR is generally calculated in organizations, and by investors using the formula:

RoR= risk-free rates + risk coefficients.

However, the risk coefficients can be determined by subtracting risk-free return from the total estimated/expected return. In summary, RoR is affected by the factors: risk of investment, the liquidity for that investment, and inflation. First, the risk of making investments is usually accommodated by the RoR because one will add the perceived risks to the investment opportunity. The rates may also be favorable, as an investor would reduce his/her RoR suppose the risks associated with that investment is lower. Secondly, liquidity is a crucial factor. In case a particular investment plan may fail to return the invested funds for quite a time, an investor would raise the RoR because the risk of investment has been increased. Lastly, financial analysis often adds the estimated RoR into the projected inflation rates after investing. For this reason, having a higher rate of inflation associated with a business might lead to a dramatic increment in the rate of return.

Cash Flow from Assets (CFFA)

By definition, CFFA refers to an overall aggregate of the summation for cash flows, which are linked to assets, for a particular business, or organization. The financial analysis primarily utilizes the information from CFFA to guide the process of determining the net amount of money in the form of cash that a business is using to run its activities or operations. Conceptionally, three fundamental principles related to cash flows can be derived based on the ideology of CFFA.

The first concept is the cash flow that is generated by business operations. These include the value of net income and additional non-cash expenses that consist of depreciation and amortization. Second is the changes or variations in the working capital. These refer to the sum of net change experienced in accounts receivable, account payable, plus the inventories that are garnered in the process of taking measurements. It is imperative that increases in the working capital involve the use of cash, while a fall in working capital leads to the production of cash. The third concept is the changes that occur with fixed assets. Such includes the changes that are usually observed in the fixed assets before the actual effect of depreciation is indicated.

Example

XYZ business enterprise earns a total of $5, 000 in the measurement time, but also reports a depreciation value of $2, 000. The enterprise also records $10 000 and $4 000 increment in the accounts receivable, and inventory respectively. There was also an observed increment in the accounts payable of $7, 000. Moreover, the enterprise used $4, 000 to acquire its fixed assets during the measurement period. The cash flows from assets CFFA is then calculated as follows;

• Cash generated from business activities = $7, 000 (earnings plus depreciation)
• Changes in the working capital = -$7, 000 [(payables)- receivables- inventories]
• Change in the fixed assets= -$4, 000 (-$4, 000 for the fixed assets used in making purchases.
• Cash flow from assets (CFFA)= -$4, 000

Conclusively, the negative value of CFFA is because the measurement does not include possible financing sources such as debts and stock sales. However, various strategies could be implemented to generate a positive value of CFFA. They include:

1. Increasing prices
2. Redesigning products to minimize material costs
3. Cutting any overhead, to low the costs of operation
4. Lengthening payment intervals for the suppliers.

Reference

Corporate Finance Institute. (2019, October 26). Operating cash flow - Definition, formula, and examples. Corporate Finance Institute. https://corporatefinanceinstitute.com/resources/knowledge/accounting/operating-cash-flow/