Question

What is the concept of present value?

Answer 1

Present value is the concept that states an amount of money today is worth more than that same amount in the future. In other words, money received in the future is not worth as much as an equal amount received today.

To be precise , receiving $1,000 today is worth more than $1,000 five years from now.

For example, if an investor receives $10,000 today and can earn a rate of return 5% per year, the $10,000 today is certainly worth more than receiving $10,000 five years from now. If an investor waited five years for $10,000, there would be opportunity cost or the investor would lose out on the rate of return for the five years.

Present value (PV) is the current value of a future sum of money or stream of cash flows given a specified rate of return. Present value takes the future value and applies a discount rate or the interest rate that could be earned if invested.

present value tells you how much you'd need in today's dollars to earn a specific amount in the future.

The discount rate is the investment rate of return that is applied to the present value calculation.

Formula

Present value = Future value ÷ ( 1+ r ) ⁿ

Where r = discount rate

n = number of years

Example :

You are promised $800 in 10 years time. What is its Present Value at an interest rate of 6% ?

PV = $800 ÷ (1+0.06)¹⁰

= $800 = 1.7908...

= $446.72