Present Value - Explained
What is Present Value?
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What is Present Value?
In economics and finance, the present value refers to today's value of future total cash flow. Present value tells you how much you will need today to achieve a certain amount in the future. On the other hand, future values give you an overview of the investments worth at a later time. This is derived from the concept that money has a time value.
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How Does Present Value Work?
The perception behind the time value of money is that receiving an item in the present day is preferred to receiving the same item at a later day. The following two factors support this statement:
- The rate of return or interest rate
For instance, let's assume that an investor is today given $1000 and chooses to invest it somewhere. In a period of 3 or 5 years, the money will have earned interest. If the investor was to be given the same amount 5 years later, he or she would have missed out on the opportunity. Money has the potential of earning interest over some time. Therefore, the present value of money should either be less or equal to its future value. But, in cases where the money earns a negative interest, then the future value becomes less than the present value.
Purchasing power and inflation
Inflation is the rise in prices of goods and services over some time. If a person receives money today, they can buy goods at the present prices. Assuming there is inflation on prices, this means that the purchasing power of your money will definitely decrease. Therefore, the number of goods you buy in the future will be less compared to the current one. When it comes to stocks and bonds, the calculation of the present value can be a complex process. This is because it involves making assumptions on growth rates and expenditures on capital. These variables, therefore, cannot be predicted accurately.
How Present Value is Calculated
Present value is calculated using the following formula:
PV = CF/ (1+r)n
PV = FV/ (1+r)n
CF = cash flow (amount of money that flows in and out of business).
FV = value in the future
r = rate of return or the interest rate
n = period
They can be computed using a financial calculator or software. You can also go the easy way to use present value tables. The tables, however, are not that accurate because their figures are rounded off.
Example of Present Value Calculation
Let's assume that you intend to purchase a car and the money you have at the moment is not sufficient. So you decide to open a savings account to help you save money. You are sure that the interest rate is 5% per year. In 10 years, you would want your money to have accumulated to $10,000. This will then be enough to buy the car you want. To know how much to deposit into your account now, you will use the present value formula. PV = $10,000/ (1 + 0.05)10 = $6,139.13 Therefore, the present value in your savings account should be $6.139.13. In 10 years, this will be worth $10,000 if it earns an interest of 5% per year. The major components that influence the present value are the interest rate, the period, and the cash flow. Investors should account for inflation by using the real rate of return (nominal interest rate the rate of inflation).
Importance of Present Value
The present value concept is essential in the following ways:
- The calculation of present value is used by investors to know the value of loans, mortgages, bonds, sinking funds, and annuities.
- The present value formula can be applied in various fields of finance like corporate, investment finance, and banking.
- It forms the basis for pension funds variations, financial modeling processes, and lottery pay-outs.
- Present value gives an estimated value of what one can spend in the present day to generate a certain amount at a given period.
Limitations of using present value
As earlier stated, using the present value formula involves the assumption that the funds will earn a rate of return over some time. However, it is not a guarantee that the funds will earn an interest due to factors like inflation. An investor, therefore, needs to be realistic and consider these factors before investing.