What is Present Value?

Bruce T.

A core principal of finance, known as the time value of money (TVM), is based on the concept that $100 US Dollars (USD) in the present is worth more than having $100 (USD) a year later. This is because someone could currently invest it and have it earning an additional income during the course of the year; also, this is the basis for present value (PV). For example, investing $1,000 USD at a five percent interest rate over the course of one year would become $1050 USD. If the $1,000 USD were received one year from the present date, it would have to be discounted by the five percent interest rate — it would be $952.38 USD, which is determined by the equation $1,000 USD ÷ 1.05. This is what is known as the present value of $1,000 USD at a discount rate of five percent.

Businessman giving a thumbs-up
Businessman giving a thumbs-up

The formula used to calculate for present value is PV = P/〖(1+i)〗^n. P stands for the principal, or cash; i equals the discount rate; and n represents the number of periods. Therefore, the values from the previous example plugged into this formula would be PV = $1,000 USD /〖(1.05)〗^1 = $952.38 USD.

To facilitate finding the present value of many values, this formula has been used to create present value tables. The amount of principal used in the formula typically is $1.00 USD. A decimal that this produces can be applied to any amount of money for a designated discount rate and is known as the present value interest factor (PVIF). The formula for this would be PVIF = $1.00 USD / (1.05) = .95238. This particular PVIF can be applied to any amount of principal for a time period of one year at a discount rate of five percent; for example, $1,000 USD x .95238 = $952.38 USD, and $4,500 USD x .95238 = $4285.71 USD.

Present value calculations are used in many ways for transacting business. They can help a person make a decision on automobile financing, paying mortgage points, or buying a business. In the financial sector, PV helps to determine spot rates on currency exchanges and value income streams from securities or real estate.

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