Present Value (PV): Definition, Formula & Calculation
A dollar today is worth more than a dollar tomorrow.
This is the classic phrase that is associated with the concept of the time value of money. But when you’re given a choice between a sum of money today payment, and a future payment, how can you figure out which one to take?
That’s where the present value calculation comes into play.
But what is the present value? And how can it be used in the business world? Read on as we take a closer look at PV.
Table of Contents
- Present value helps to figure out whether a sum of money today is worth more than a sum of money in the future.
- When calculating present value, a rate of return is assumed.
- Present value is a quick and easy calculation. However, it can come at the expense of accuracy.
What Is Present Value (PV)
Present value (PV) is the current valuation of a sum of money in the future. It can also be the future sum of a stream of cash flows. Though this is with a specified rate of return. Future cash inflows are typically discounted at the discount rate. This works by the rule that the higher the discount rate is, the lower the present value of the future cash flows will be.
When it comes to being able to properly value future cash flows, figuring out the correct discount rate is key whether they be debt obligations or earnings.
Formula Of Present Value
When looking at the present value of a sum of money or cash flow, you can use the following formula:
How to Calculate Present Value
The present value calculation is made up of three steps. They are as follows:
1. Input the future value of the amount you expect to receive in the numerator of the formula.
2. Figure out the interest rate that you are expecting to receive between now and the future. Put the rate as a decimal number in place of the “r”.
3. Put in the time period in the place of the “n”. For example, if you wanted to figure out the present value of an amount that you’re expecting to receive in three years’ time, place the number “3” for the “n”.
There are a number of different present value calculator applications that are available to make this easier for you.
Example of Present Value
Let’s say that Company X is given the choice of payment. They can be paid $20,000 today for a section of their business where they earn 3% annually. Or they can be paid $22,000 exactly a year from now. Which of the options would be the best for the company?
To figure this out, we can take the information we’ve been given and apply it to the present value formula and calculation.
Using the formula, we can see that the calculation would be as follows:
PV = $22,200 / (1 + .03)1 = $21,359.20
So the present value of the $22,200 would be $21,359.20. This would be the minimum amount that Company X would have to be paid today to have $22,000 one year from now. This clearly shows that if Company X was paid $20,000 today with a 3% interest rate, they would end up with less money than if they took the $22,000 one year from now.
Alternatively, you could figure out the future value of the first sum of money in a year’s time. The calculation would be as follows:
PV = $20,000 x 1.03 = $20,600
Importance Of Present Value
Present value allows a solid basis where you can assess the level of fairness of any financial liabilities or benefits at a future date. So for example, a future cash rebate discounted to present value could or could outweigh the downsides of having a higher potential purchase price. The same calculation can be applied to 0% financing when someone buys a car from a dealership.
Pros and Cons of Present Value
Calculating present value is important when it comes to determining the potential value of an investment. Although it is a useful tool, it has some downsides. Let’s take a look at some of the pros and cons of present value.
Advantages of Present Value
Using present value is a quick and easy way to assess the present and future value of an investment. Investors can use the calculation to get a quick overview of the situation and whether it would be a good idea to invest money today, assuming a consistent annual rate of return.
Essentially, present value is an effective way of comparing investment decisions or purchase decisions. This is done by evaluating the future sums of money in the present day.
Disadvantages of Present Value
The present value formula assumes that you are earning an expected forgone rate of return over a predetermined period of time. This can make present value a misleading statement.
For example, if you were to invest in a company, the assumed rate of return could end up changing in each of the following three years. This could be due to a number of factors such as volatility in the industry or market.
In the case of not having a consistent rate, it wouldn’t be so easy to calculate the present value. Because you wouldn’t be able to use a realistic annual rate of return.
Present value is a quick and easy way to get a good idea of the value of a sum of money or cash flow. However, the ease comes at the cost of accuracy which can lessen the financial benefits.
Many things can affect investments – such as inflation. So make sure that you use other metrics alongside present value to get the best idea possible.
FAQs About Present Value
Present value is used as a starting point for assessing the fairness of a future financial liability or benefit.
Put simply, a present value is good if it is greater than zero. So if your $1 today is worth $2 tomorrow, then you’d have a PV above 1. However, if your $1 is worth $0.90 tomorrow, your PV will be less than 1.
When it comes to present value, there are two rates that affect it. These are the discount rate and the interest rate. If the discount rate is lower, then the present value is higher. Whereas if the discount rate is higher, then the present value will be lower.
Future value is the total sum of money that will accrue over time when that initial sum is invested.
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