Exploring Careers – Finance Practice Test

This question tests the time value of money: money today is worth more than money in the future, so we translate future cash flows into their value in today’s terms by discounting at a given rate. Present value is the current worth of a future cash flow when discounted at a rate because the discount rate accounts for factors like opportunity cost, risk, and inflation, reducing the future amount to its value today. For example, if you’re promised $100 three years from now and the discount rate is 5%, the present value is about $86.29, since 100 divided by (1.05)^3 equals roughly 86.29.

Other descriptions miss this time-value aspect: simply summing future cash flows ignores the fact that future money is worth less today, referring instead to the future value rather than today’s value; or they describe equity value, which is a broader concept not specific to translating a single future cash flow into today’s terms.