Present value

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The present value of a future cash flow is the nominal amount of money to change hands at some future date, discounted to account for the time value of money. A given amount of money is always more valuable sooner than later since this enables one to take advantage of investment opportunities. Because of this present values are smaller than corresponding future values.

The simplest model of the time value of money is compound interest, which is in fact much simpler than simple interest. To someone who has the opportunity to invest an amount of money $C$ for $t$ years at a rate of interest of $i$ % compounded annually, the present value of the receipt of $C$ , $t$ years in the future, is:

$C_t = C(1 + i/100)^{-t}.\,$

The expression (1 + i/100)^−t enters almost all calculations of present value. It represents the present value of 1. Many equations are expressed more concisely by making the substitution v = (1 + i/100)⁻¹. Something worth 1 at time = t (years in the future) is worth v^t at time = 0 (the present). If the interest rate is expected to change during the payback period it is common to use these different interest rate estimates for the future timeperiods. An investment over a two year period would then have PV (Present Value) of

$\mathrm{PV} = C(1+i1/100)^{-1}\cdot(1+i2/100)^{-1}.\,$

The interest rate used is the risk free interest rate (for example the rate of return on US treasury bonds). If there are no risks involved in the project, the expected rate of return from the project must equal or exceed this rate of return or it would be better to invest the capital in these risk free assets. If there are risks involved in an investment this can be reflected through the use of a risk premium. The risk premium required can be found by comparing the project with the rate of return required from other projects with similar risks. Thus it is possible for investors to take account of any uncertainty involved in various investments.

Present value is additive. The present value of a bundle of cash flows is the sum of each one's present value.

Many financial arrangements (including bonds, other loans, leases, salaries, membership dues, annuities, straight-line depreciation charges) stipulate structured payment schedules, which is to say payment of the same amount at regular time intervals. The term annuity is often used in to refer to any such arrangement when discussing calculation of present value, whether or not the arrangement is a retirement plan. The expressions for the present value of such payments amount to summations of geometric series.

A periodic amount receivable indefinitely is called a perpetuity and is of mostly theoretical interest. A perpetuity receivable starting at the present time is called a perpetuity due. If the frequency of payments equals the frequency of interest compounding, the present value of a perpetuity due with payments of 1, is given by d⁻¹, where d = 1 − (1 + i)⁻¹, and is called the rate of discount. In this case, i is the interest rate per period, not necessarily per year. If the first payment is 1 period in the future, the annuity is a perpetuity immediate, and the present value is i⁻¹.

A finite number (n) of periodic payments, receivable at times 1 through n, is an annuity immediate. Again assuming payment size of 1, its present value differs from the present value of the corresponding perpetuity immediate by an amount that is the present value of all the payments numbered n + 1 and above. The latter has a value of i⁻¹ at time n, and vⁿi ^{− 1} at time 0. The present value of the annuity immediate is i⁻¹ − vⁿi⁻¹, or i⁻¹(1 − vⁿ). An annuity due receivable at times 0 through n − 1 has a present value of d⁻¹(1 − vⁿ).

This entire discussion thus far makes some enormous assumptions:

That it is not necessary to account for price inflation.
That we will live long enough to receive payments receivable by us in the future.

For these and many other reasons, we consider prediction of the future value to be an inexact science.

[edit] Present value formula

One hundred units 1 year from now at 5% interest rate is today worth:

${\rm Present\ value}=\frac{\rm future\ amount}{(1+{\rm interest\ rate})^{\rm term}}=\frac{100}{(1+.05)^1}=\ 95.23.$

So the present value of 100 units 1 year from now at 5% is 95.23 units.

The above is in regard to a single lump sum amount. There is a separate formula to calculate PV of annuities. For present value of annuities, use this formula:

$\mbox{PV annuity} = \frac{1-(1+r)^{-n}}{r}\cdot(\mbox{payment amount}).\,$