Steps involved in calculation of Present Value Factor (P.V.F)
The following steps are involved in the preparation of present value
1. Cash outflows of the first year is taken as it is since the cash outflows of one rupee is equal to one rupee.
2. Cash inflows for different periods are considered as cash received after tax but before depreciation.
3. Cash inflows is considered for full economic life of the project.
4. The salvage value or scrap value of the project is considered as cash inflows.
5. Both cash inflows and cash outflows should be discounted at a predetermined discount rate.
6. Generally, cost of capital of a firm is considered as discount rate. It is otherwise called as cut-off rate.
7. If the management wishes the discount rate is other than the cost of capital, the decision of management is final, such rate is taken as discount rate. In this case, generally, discount rate is some what higher than the cost of capital.
8. The present value factor is identified with the help of discount rate.
Formula to calculate P.V.F
The following formula is used to find the present value factor.
P.V.F = Present Value Factor
r = Discount Rate
n = Number of years
The following example clears the calculation of present-value factor.
- Discount rate is 12%.
- Number of year is three.
- The present value factor is 0.712
0.712 means means that Rs.1000 receivable after 3 years is equal to Rs.712 today. In other words, Rs.712 invested today at 12% will bring Rs.1000 after three years.
9. Then, the present value of cash inflows for different values are calculated with the help of present value calculator at 12%.
10. The cash outflows at subsequent periods are discounted at the same rate of present value factor.
The present value of total cash inflows should be compared with the present value of total cash outflows. If the present value of cash inflows are greater than (or equal to) the present value of cash outflows (or initial investment), the project would be accepted. If not so, then the project will be rejected.
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