Present value, also known as present discounted value is based on two fundamental principles:
The preference for immediate gratification ;
Risk aversion .
Principle : the time value of money
The first principle is often confused in what is called the cost of time as opposed to the second principle corresponding to the cost of risk.
The cost of time reflects the fact that the euro today is worth more than the euro tomorrow.
In finance, the cost of time is shown by the curve called risk-free rate (eg , yields on government bonds are generally considered a good proxy for risk-free rate). Indeed a euro today can be invested and bring more euro tomorrow.
The cost of risk, in turn, reflects the fact that some euro is worth more than Euro expected. The cost of risk is represented by the risk premium which adds to the risk-free rate to be expected on a risky asset (such as a stock or bond).
In practice, present discounted value is used to measure the appropriateness of an investment due to two main questions:
measure the value of an asset of any kind: how is it for me today, given that I think it will bring me a return in the future? We can then determine the return
compare several options for assigning an asset, such as money : invest (purchase or lease ? ) deleverage, conserve cash, etc. .
An investment is profitable if its present value is greater than its purchase price, the ratio between the two measuring return on investment, the best use of an asset is the one that has the highest present value .
The concept of present discounted value in finance
In practice, two rates are used to measure changes in the value of money :
- the notion of risk-free rate that covers the cost of time (usually one takes as reference rates for borrowings of a solvent state).
- the notion of risk premium that covers uncertainties expectations of future income, or more precisely the price of aversion to this uncertainty ( risk aversion) .