Present Value (PV) is the amount of money you expect to get from your future potential income today. It is obtained by adding up the expected returns on future investments and discounting them at a certain expected rate of return. In other words, it’s how much a series of payments is worth right now instead of at some time in the future when the payments are actually due.
So, what’s the importance of present value? Let’s say you got Rs. 10,000 today. It is more valuable than the Rs 10,000 collected after four years. The reason for this is because you have a chance to earn interest on the amount. It might be 4–6% or even higher, depending on where you invest the money. You will not receive the rate of return if you receive Rs 10,000 after four years.
If you get money today, you can buy things or use services at the current rate. Things become expensive due to inflation, which is the increased cost of products and services. In layman’s words, inflation reduces the value of money for purchases. Money loses value if you don’t invest it because of inflation.
The concept of Present Value is applied to financial modelling, stock valuation, bond pricing, and the evaluation of various investment options. To determine whether an investment is worthwhile making today, the investor estimates a present value from the investment’s projected cash flow. A discount rate, which is the projected rate of return determined inversely with future cash flow, is applied to the expected cash flow of the future.
Due to inflation, the prices of goods and services go up over time, which makes money worth less because what it is worth today might not be worth the same tomorrow. PV calculations make sure that the expected rate of return or the inflation rate is used to figure out the effect of inflation.
Discount Rate for Finding Present Value
The investment return rate used in the present value computation is called the discount rate. Given that it represents the anticipated rate of return you would experience if you had invested today’s money for a period of time, the discount rate that is used for the present value calculation is very subjective. In other words, if an investor chooses to accept an amount in the future as opposed to the same amount today, the discount rate would be the forgone rate of return.
The hurdle rate, also known as the risk-free rate of return, is frequently calculated and used as the discount rate in numerous situations.
The discount rate is the result of adding an applicable interest rate to the time value, which raises future value mathematically. A lender can determine the fair amount of any future earnings or liabilities in relation to the present value of the capital by using the discount rate, which is used to calculate future value in terms of present value. Future value is discounted to current value when the term “discount” is used.
Calculation of Present Value
Here’s the Present Value(PV) formula:
PV = Future Value / (1+i)^n
Where,
FV is the future value
I is the rate of return
n is the number of periods
Here are the steps to calculate the Present Value:
Step 1: Enter the investment’s future expected value
Step 2: Put the expected rate of return on your investment
Step 3: Enter the length of the investment period
Let us look at an example to understand the working of the PV formula.
We are assuming that you have the option of receiving Rs.2,200 one year from now instead of Rs.2,000 today at 3% annually.
According to the present value formula, PV= Rs.2,200 / (1 +. 03)^1 = Rs. 2,135.92
The present value represents the minimal amount that would need to be given to you today for you to have Rs.2,200 in one year. To put it another way, even if you received Rs.2,000 today at a 3% interest rate, you wouldn’t receive Rs.2,200 in a year.
Instead of calculating the PV manually, one can use an online Present Value calculator to calculate the present value in a jiffy.
Net Present Value
Another concept that is confused with Present Value is Net Present Value(NPV).
Given a specific rate of return, present value (PV) is the current value of a future financial asset or cash flow stream. Net present value (NPV), on the other hand, is the difference between the present value of cash inflows and outflows over a period of time.
Net present value assesses how profitable a project or investment might be. NPV and PV may be crucial when a person or business makes investment decisions.
Here’s the Net Present Value formula:
Net Present Value = cash flow/(1+r)^t − initial investment
where r is the rate of return and t is the total time periods.
What Is the Present Value of an Annuity?
The amount of money required today to fund a series of future annuity payments is referred to as the annuity’s present value. Given a specific rate of return, or discount rate, the present value of an annuity is the current value of the payments from an annuity in the future. The present value of the annuity decreases as the discount rate increases.
The formula for the present value of an Annuity =
PMT * {1- (1/(1+R)^N)} /R
where:
PMT is the amount of each annuity payment
R is the interest rate/discount rate
N is the number of times payments will be made
Conclusion
Present Value (PV) is one of the key concepts in finance. Although it sounds fancy and complicated, it is actually pretty simple. PV provides a way to calculate how much money you need today to have a certain amount of cash at a future date. Often, this concept will be used in an investment setting.
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