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Present Value
If you are expecting to receive some money in the future, the present value tells us how much that money is worth today.
Example: If you get $200 in ten years that is not the same thing as getting $200 today because if you had that money today you could invest it in the market and turn it in to a higher value in the future.
Where:
i = interest rate
n = years (or time periods)
If you are going to receive $100 in three years and the interest rate is 7% what would be the present value?
Present Value =
This means getting $100 in three years is the same thing as getting $81.63 today because if you had $81.63 today you could invest it in the market at 7% and turn it in to $100 in 3 years.
If you are expecting to receive some money in the future, the present value tells us how much that money is worth today. Example: If you get $200 in ten years that is not the same thing as getting $200 today because if you had that money today you could invest it in the market and turn it in to a higher value in the future.
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Example: Present Value
Which of the following would cause the present value to fall?
A) a decrease in the interest rate
B) an increase in the interest rate
C) an increase in the time to the promised future payment
D) B and C
D
Interest rate is in the denominator of the formula and whenever the denominator gets bigger the present value will get smaller. Time to promised future payment means the letter n in the formula and since it's in the denominator again if it gets bigger it will mean the present value will get smaller.
Practice: Present Value
You have just won the lottery and you have two options:
Option 1: Receive $150,000 in five years
Option 2: Receive $120,000 today.
If the current interest rate (yield) is 6%, which option should you take?