BNET Basics

Assessing Present Value

by BNET Editorial

Tags: interest rate, inflation, investment, present value, future value, strategy, tool

�Present value� is the current value of a future sum of money.

A concept known as the �time value of money� asserts that a certain sum today is worth more than the same sum tomorrow. This partly comes down to inflation, but also the effect of investment�it�s better to be paid $100 today than in five years� time, because the money could be invested now and earning interest.

Present value calculates how much money would need to be invested today (at an estimated interest rate) to result in a given sum at a specified point in the future. It�s a useful planning tool for companies and investors needing to know the true value of expected income and expenditure.

What to Do

The formula for present value is:

1 / (1 + i)n = Present value

Where i is the estimated interest rate (expressed as a decimal), and n is the number of years being considered.

The task is made easy by present value calculators that are often integrated in computer spreadsheets. Alternatively, present value tables can be used. These show how the value of $1 (or other unit of currency) decreases over time at given interest rates. Typically, tables give annual figures for 25 or 30 years, and then every five years up to 50.

Example:

A company expects to receive a payment of $6,000 in three years� time. Interest is estimated at 3%. After three years at 3% interest, the value of $1 shrinks to $0.915142, or�expressed as a formula�1 / (1 + 0.03)3. So present value is 6,000 � 0.915142 = $5,490.85.

What You Need to Know

Present value depends on assumptions made about interest and inflation, so the answer is only as accurate as the estimate.
Present value tables are not the same thing as annuity tables or a future value tables�it�s important to use the correct one.
The principle of present value is easy to understand, but the calculations can be very complex�for example, when they involve varying interest rates compounded daily. These are best left to people with a high level of expertise.