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About Present Value and Discount Rates

Owned by admin (Deactivated)
Jan 30, 2018
3 min read

The Aptify Fundraising module supports the concept of computing the present value of pledges that will be received over a period of time. Pledges are often paid in installments over a year or more. Understanding this feature requires an understanding of two important concepts in finance: Present Value and Discount Rates.

Present Value (PV) is defined as the value in current dollars of a stream of revenue that will be received at some point in the future. From a financial standpoint, a dollar received in the future is not worth as much as a dollar received today. The reason future cash flows are not as valuable has to do with the time value of money. A dollar received today can be used for a variety of purposes. It can be used by an organization to fund current operations, paid out as distributions to owners (in for-profit enterprises), invested in new land, plants, and equipment, or invested in marketable securities. A dollar received in one year cannot be used today for any of these purposes and is worth less to the organization. The system automatically performs PV calculations for you while generating the appropriate GL entries that recognize revenue over time.

Present Value Example

Donor A contributes $93.46 in cash today. Donor B pledges to donate $100 in cash in one year. The economic value of Donor A's contribution in present value terms is $93.46. The funds can be used immediately for any purpose. Donor B's pledge is worth less than $100 in present value terms. Although the organization will receive $100, the funds are not available for one year.

Assume that Donor A's pledge can be invested in a marketable security earning seven percent interest. At the end of the one year, the $93.46 contributed by Donor A will be worth $100 (93.46 x 1.07). The present value of Donor B's contribution, assuming that it is invested in a security bearing seven percent interest, is 100/1.07 = 93.46. In other words, $93.46 contributed today results in the same amount of money as $100 donated in one year.

Donor A and Donor B have made pledges that are equivalent in economic value to the organization even though the nominal dollar amounts are not the same.

 


The concept of discount rate is critical in present value computations. In the previous example, we used a discount rate of seven percent because the funds could be invested at a seven percent rate. Discount rates are determined by a combination of current investment opportunities and the risk of not receiving the cash. In most cases, organizations establish a discount rate that will change periodically to reflect shifting market conditions and economic risks.

The general formula to compute the present value (PV) of a future cash flow (CF) using an annual discount rate (r) is PV = CF/(1+r)^t, where t is time expressed in years.

Discount Rate Example

What is the present value of the following pledge: $150,000 received in one year, $200,000 received in two years, and $500,000 received in five years? Assume a discount rate of 8 percent:

PV = 150,000/1.08 + 200,000/(1.08)^2 + 500,000/(1.08)^5
PV = 650,648.30

Although the total amount of the pledge is $850,000 paid in installments, the economic value of the pledge to the organization is $650,648.30.

 

 

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