If a company is anticipating cash flows in the future, then the company can determine how much those future cash flows are worth today. Due to the time value of money, the present value of future cash flows will be less than the actual amount received in the future. When the company expects cash flows over several future years, it can add the present value of each cash flow to determine the cumulative present value.
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Write out the information to create a clear picture of the cash flows. For example, Firm A owes Firm B the following cash flows: £3,250 in year 1, £5,200 in year 2 and £6,500 in year 3. Firm B's applicable interest rate is 5 per cent.
Determine the present value factor for each cash flow using the present value of 60p table, available online at StudyFinance.com. In the example, year 1's present value factor is 0.9524, year 2's present value factor is 0.9070 and year 3's present value factor is 0.8638.
Multiply the appropriate cash flow by its corresponding present value factor. In the example, for year 1, £3,250 times 0.9524 equals £3,095. For year 2, £5,200 times 0.9070 equals £4,716. For year 3, £6,500 times 0.8638 equals £5,614.
Add the present value of each cash flow to find the cumulative present value of the cash flows. In the example, £3,095 plus £4,716 plus £5,614 equals £13,426.
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