Present Value

Present Value Definition

Present Value (PV) is today’s value of money you expect from future income and is calculated as the sum of future investment returns discounted at a specified level of rate of return expectation.

This concept is used in the valuation of stocks, bond pricingBond PricingThe bond pricing formula calculates the present value of the probable future cash flows, which include coupon payments and the par value, which is the redemption amount at maturity. The yield to maturity (YTM) refers to the rate of interest used to discount future cash flows.read more, financial modeling, and analysis of various investment options. The investor calculates a present value from the future cash flow of investment to decide whether that investment is worth investing in today. The expected cash flow of the future is discounted at a discount rate, which is the expected rate of return calculated inversely with future cash flow. Inflation reduces the value of money in hand since the price of goods and services rises over a period due to inflation, which means the amount worth today might not be equally worth tomorrow. PV calculations make sure the inflationary impact is calculated from either inflation rate or expected rate of returns.

How to Find Present Value?

PV = Future Value / (1+i)n

  • i = interest rate
  • n = investment period

Step #1 – Put expected future value of the investment in a formula

Step #2 – Put Expected rate of return on your investment

Step #3 – Number of the period you are investing

Present-Value

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Examples of Present Value

You can download this Present Value Excel Template here – Present Value Excel Template

Example #1

Mr. X wants $10,000 after 3 years. The interest rate available on a specific investment, which he is interested in, is 4% per annum. How much he should invest today to receive the desired amount.

Solution

Given,

  • Future Value = $10,000
  • Interest = 4% per annum
  • Period = 3 years

Calculation of Present Value can be done as follows,

Present Value Example 1
  • = $10,000 / (1+0.04)3
  • = $8,889.96

i.e., Mr. X should invest $8,889.96 amount today to get the desired amount in 3 years.

Example #2

Mr. A has $100,000 in hand from his savings; he wants $200,000 after 10 years. He has three options i.e., either

  1. Bank deposit at a rate of 4% per annum compounded quarterlyCompounded QuarterlyThe compounding quarterly formula depicts the total interest an investor can earn on investment or financial product if the interest is payable quarterly and reinvested in the scheme. It considers the principal amount, quarterly compounded rate of interest and the number of periods for computation.read more.
  2. Government bonds at 3.85% for 10 years.
  3. Invest in a Hedge fund with expected returns of a minimum of 8% per annum. Which investment option is best to achieve his goals?

Calculation of Present Value for Option A can be done as follows,

Present Value Example 2
  • =$200000.00/(1+1%)40
  • = 134330.63

Similarly, we can calculate PV for Option B and Option C

Example 2.1

By looking at the table above, the answer seems quite simple as an investment in option C i.e., hedge fundsHedge FundsA hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund. It supports various assets providing high returns in exchange for higher risk through multiple risk management and hedging techniques.read more give more returns, which help Mr. A to achieve his future investment returns, while investment options of bank deposits and government bonds will need an additional investment of $34,330.64 and $37,077.12 on current amount in hand to achieve the desired return of $200,000.

At first, the choice seems simple to Mr. A to select investment option C, but investment in hedge funds also involves risk of loss that needs to be considered, which means there is no guaranty that investors will definitely earn expected future returns.  While Option A and B, which are bank deposit and investment in government bonds, may not provide expected returns but includes very low risk on investmentLow Risk On InvestmentLow-risk investments are the financial instruments with minimal uncertainties or chances of loss to the investors. Although such investments are safe, they fail to offer high returns to the investors. read more.

Depending on Mr. A Financial condition, risk capacity decisions can be made. While conservative investor prefers to select Option A or B, an aggressive investor will select Option C if he is ready and has the financial capacity to bear the risk.

Importance

Benefits

  • Investment Decision: This method helps in making investment decisions since it calculates the current value of future cash flows in investment. If the investor does not have enough amount to invest from which he expects future cash flow, he would prefer to select other investment options.
  • Purchasing Power: Money worth today is more than the money worth tomorrow, which means a value of $100 today might not be equal to $100 after a year because of inflation reduces the value of money. Present consider inflation and provides details on whether today’s investment is enough for future cash flow.
  • Discount Rate: Rate of returns on investment to calculate it is called a discount rate. In other words, a combination of the time value of money, which reduces over a period, and interest rate, which raises the value of your investment. A discount rate is used to calculate the PV of the investment in case of a settlement, by discounting future value.

Limitation

Present Value vs Future Value

Present ValueFuture Value
DefinitionCurrent Value of Future Cash flow is called Present ValueFuture cash flow resulting  after a certain period on today’s investments is known as Future value
WhenIt focuses on value at the beginning of a periodFuture Value focuses on Value at the end of the period
RateInterest rates and discount rates both need to consider in the calculation of PVOnly the interest rate is considered while calculating future value.
DecisionIt is important to make the decision today regarding a particular investment.Future Value provides a number which will receive in the future, which does not affect decision making today.
MethodsDiscountedCompounding to get resulted amount on a future date
ViewsIt is required to get a certain future value.Future value provides the value of the current investment in the future.

Conclusion

Present value calculation helps in making many investment decisions for the business as well as individuals; although the exact value cannot be calculated because of changing interest rates on many investments and inflationary effects, this calculation still helps in estimating individuals’ money worth in terms of his future expectation.

Since the present value is calculated at the beginning of the period while making investment decisions, it includes some assumptions regarding inflation and the rate of returns on investment, which should be realistic and proper analysis; a comparison of various investment options is necessary to find the right plan to invest.

Recommended Articles

This has been a guide to Present Value and its definition. Here we discuss how to find present value along with examples, benefits, limitations, and differences from future value. You can learn more about financing from the following articles –

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