Present value

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Present value is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk. Present value calculations are widely used in business and economics to provide a means to compare cash flows at different times on a meaningful "like to like" basis.

Contents

Background

If offered a choice between \$100 today or \$100 in one year and there is a positive real interest rate throughout the year ceteris paribus, a rational person will choose \$100 today. This is described by economists as Time Preference.[citation needed] Time Preference can be measured by auctioning off a risk free security - like a US Treasury bill. If a \$100 note, payable in one year, sells for \$80, then the present value of \$100 one year in the future is \$80. This is because you can invest your money today in a bank account or any other (safe) investment that will return you interest.[clarification needed]

An investor who has some money has two options: to spend it right now or to save it. But the financial compensation for saving it (and not spending it) is that the money value will accrue through the interest that he or she will receive from a borrower (the bank account on which he has the money deposited).

Therefore, to evaluate the real value of an amount of money today after a given period of time, economic agents compound the amount of money at a given (interest) rate. Most actuarial calculations use the risk-free interest rate which corresponds the minimum guaranteed rate provided by your bank's saving account for example. If you want to compare your change in purchasing power, then you should use the real interest rate (nominal interest rate minus inflation rate).

The operation of evaluating a present value into the future value is called a capitalization (how much \$100 today are worth in 5 years?). The reverse operation—evaluating the present value of a future amount of money—is called a discounting (how much \$100 that I will receive in 5 years—at a lottery for example—are worth today?).

It follows that if one has to choose between receiving \$100 today and \$100 in one year, the rational decision is to choose the \$100 today. If the money is to be received in one year and assuming the savings account interest rate is 5%, the person has to be offered at least \$105 in one year so that two options are equivalent (either receiving \$100 today or receiving \$105 in one year). This is because if you cash \$100 today and deposit in your savings account, you will have \$105 in one year.

Calculation

The most commonly applied model of the time value of money is compound interest. To someone who can lend or borrow for $\,t\,$ years at an interest rate $\,i\,$ per year (where interest of "5 percent" is expressed fully as 0.05), the present value of the receiving $\,C\,$ monetary units $\,t\,$ years in the future is: