Present Value Analysis

 In developing long-term projects, it is often difficult to compare today's costs with the full value of tomorrow’s benefits. As we have seen, the time value of money allows for interest rates, inflation, and other factor’s that alter the value of the investment. Furthermore, certain investments offer benefit periods that vary with different projects. Present value analysis controls for these problems by calculating the costs and benefits of the system in terms of today's value of the investment and then comparing across alternatives.

A critical factor to consider in computing present value is a discount rate equivalent to the forgone amount that the money could earn if it were invested in a different project. It is similar to the opportunity cost of tile funds being considered for the project.

Suppose that $3,000 is to be invested in a microcomputer for our safe posit tracking system, and the average annual benefit is $1,500 for the four-year life of the system. The investment has to be made today, whereas the benefits are in the future. We compare present values to future values by considering the time value of money to be invested. The amount that we are willing to invest today is determined by the value of the benefits at the end a given period (year). The amount is called the present value of the benefit.

To compute the present value, we take the formula for future value = P/(l + i) and solve for the present value (Pl as follows:

                                                               P = (1 + i)

So the  present value of $1,500 invested at 10 percent interest at the end of fourth year is:

                         1,500

                     --------------

                      (1 + 0.10)4

                 1,500 = $1,027.39

                 --------

                   1.61

That is, if we invest $1,027.39 today at 10 percent interest, we can expect to have $1,500 in four years. This calculation can be represented for each year where a benefit is expected.