The present value is, many times, referred to as the discounted value – and it a widely used financial formula. So, what it is used for? Expressly, it estimates the amount of money that ought to be invested today, to equal the payment received on a specific future date. This concept is connected to the time value principle which assesses that one dollar today is, usually, worth more than one dollar tomorrow. This is due to three primary reasons, namely interest, opportunity costs and inflation.
Moving on, debtors are required to pay an interest rate to creditors, granted that they want to borrow funds. In the meantime, creditors’ funds aren’t idle – quite the opposite. They continually aim at making money in the form of interest – which is why cash could be conveyed as a costly commodity.
At the same time, inflation contributes to depreciating the purchasing strength of today’s market as time goes on. For instance, if we were to take a five-dollar bill from the 1950s, we couldn’t use it to purchase as much in 2018, as we would have back in the day. Of course, unless that sum of money is earning interest at the rate of inflation, it will inevitably lose its value over time.
For example, five dollars in 1950, in 2015 are actually worth approximately $50. To be more specific, a dollar in 1950 is worth ten times a dollar in 2015. To that end, we could argue that present money is more valuable than future money.
Understanding the Present Value Formula
Moving on, the formula for the present value is the following:
So, what does each symbol stand for? Firstly, c1 represents the cash flow from 1 period. The R stands for the rate of return, whilst n represents the number of periods.
It is clearly observable from this preset value equation that a range of the variables ought to be estimated. In regard to the cash flow period, it is merely the amount of money received on a future date. This might also be referred to as the future value of a lump sum.
Meanwhile, the rate of the return stands for the estimated annual interest rate that ought to be received in the foreseeable future. Moving on, the number of periods accounts for the number of times the interest is expected to compound over time.
Bear in mind that this equation utilizes annual interest. Therefore, both the number of periods and the rate are in years. Thereupon, if you aim at calculating the semi-annual interest, then, simply divide the numbers in half.
You should know that this ratio is widely utilized by creditors and investors alike to assess potential investments and evaluate the return on specific projects. In essence, the time value of money concept is quintessential as it enables investors to pinpoint the worth of their investment returns. Concurrently, this is helpful for assessing whether there are better options to choose from or not.