What is the effect of falling interest rates on present value?

When interest rates fall, the present value of future cash flows increases. This relationship is grounded in the concept of the time value of money. Present value is determined by discounting future cash flows back to the present using a specific interest rate.

When the interest rate decreases, the discounting effect is less pronounced. That is, future cash flows are multiplied by a smaller factor when calculating their present value, leading to a higher present value. Essentially, as the cost of capital (or the rate of return required) declines, the value of receiving cash in the future becomes more attractive compared to holding money today.

This principle is crucial in finance because it helps in evaluating investments, pricing bonds, and making other financial decisions where cash flows are expected in the future. Understanding this relationship empowers investors and businesses to make informed decisions in a fluctuating economic environment.