Define the term present value, and provide an example.

Question

What will be an ideal response?

Answer 1

Present value analysis is a technique that adjusts all future costs and benefits of a proposed information system to a current value, called the present value. By taking into account the timing of costs and benefits, this technique compares all costs and benefit items on an equal yardstick, regardless of whether they occur now or five years from now. The present value concept is based on the time value of money.
To perform present value analysis, you must select a specified interest rate, called a discount rate that represents a safe investment return that a company might expect from investments, such as bonds. Many companies require a rate of return that is even higher than the discount rate because there is a degree of risk in any project compared to investing in a bond.
When you time-adjust the cost and benefit figures, you multiply each of the projected benefits and costs by the proper present value factor, which depends on when the cost will be incurred or the benefit will be received. Then you sum all the time-adjusted benefits and the time-adjusted costs and calculate the net present value (NPV) of the project, which is the total present value of the benefits minus the total present value of the costs.
To help you perform present value analysis, adjustment factors for various interest rates and various numbers of years are calculated and printed in tables called present value tables.