Understand the concepts of present and future value and be prepared to explain these concepts. Be able to explain, where, when, and why present and future value is used in financial accounting.
Present and Future Value Analysis in Financial Accounting
With the ramified changes in the time, value of the money also get changed throughout the time. Both future value and present value of money are different from each other and both of these go in parallel direction.
The future value (FV) analysis and measures the nominal value of the future sum of money which is based on the sum of money at specified time in future. This future sum of value of the present value is determined on the basis of the influencing factors such as interest rate, return on capital employed and rate of return (Ehrhardt, and Brigham, 2016). On the other hand, present value of the money in financial accounting is the value or amount of indicator of the payment or payment made in instalment at other times (Malenko, 2018). It is analysed that process of finding of Present value from the future value is called discounting of the value of the assets. The formula for computing the present value is given as below (Burns, and Walker, 2015).
Source: (Malenko, 2018).
It is analysed that future value of the project is always higher than the present value.
It is observed that Present value of the assets and future value of the assets are related to each other and carry different value at different. These both values increases due to the increase in the interest rate and other discounting economic factors.
Source:- (Duchin, and Sosyura., 2014).
However, in order to compute the future value of the assets following formula is used (Duchin, and Sosyura., 2014). It is analysed that present value of the assets vary directly to Future value of the assets in financial accounting as when one increases, the other one started to increases as well. These both value is considered to identify the future viability of the project and assessing the cash inflow of the different project while opting the one (Ehrhardt, and Brigham, 2016).
The computation of the present value and future value is done when company or investors wants to assess the capital investment projects. The assessment of the both value reveals the true value of the cash inflow and outflow associated with the particular financial project (Haxholli, 2015).
The below given example could be used to explicit the use of the present value and future value of the project (Gao, and Wong, 2017).
This image shows that if investor invest his capital at present then he will have to invest $ 10,000 and later on he will get amount invested value plus interest (Malenko, 2018).
Source:- (Malenko, 2018).
These both future value and present value of the capital in financial accounting is computed when investors wants to identify which project would give higher return to him considering the invested value, time value of money and changing capital value due to other factors. For instance, if investors has investment option of $ 10,000 in three projects then at that time, he will firstly identify the present value of the future cash inflow of these projects and it will be compared with the initial investment. The project which will offer higher return considering the time value of the money based on the discounting factors will be accepted for that project (Zhu, 2014).
The computation of the present and future value of the invested project in financial accounting is done to identify the true return on capital employed earned in particular project. It reduces the chances of the errors and identify the true value of future value at present and what value it carries in future. If in capital budgeting, computation of the present value and future value is not done then investors might fail to assess which project has higher return on capital employed and which one will be better investment option for him. For instance, particular investment option may give higher cash inflow but if due to time value of money it might result to negative cash outflow for business. Therefore, discounting factors should be assessed by the investors before investing the capital in identified project investment options.
Now in the end, the main crux is that computation of the present value and future value of the cash inflow and outflow in particular investment option is required to eliminate the discounted value of capital in different time period. This will help investors to assess which investment option is more beneficial for his investment purpose.