Present value is the current value of a future amount.
In simple terms, if you are getting a certain amount in the future, the present value helps you calculate the value of the amount as of today.
Present value has several applications in day-to-day life. You want to plan for your kid's college education after 10 years, and the fees is going to be £30,000. Using present value, you can calculate whether your present savings are enough to fund this expense after 10 years. Taking an annual interest rate of 4%, the present value of £30,000 after 10 years is £20,266.93. If you have savings of £20,266.93, you need not worry. If not, you can plan your savings in such a way that you have £30,000 at the end of 10 years.
In order to calculate present value, you need to have the following information:
Future value: This is the amount you will receive or require in the future. In the example above, the future value is £30,000. You cannot calculate the present value until you know the future value.
Number of payments: This refers to the term of payments, which can be in years or months. In the above example, the number of payments is 10 (years).
Iinterest rate: Using the interest rate, you can calculate how much is the present value of an amount at a future date.
Payment frequency: The frequency of payments can be monthly, quarterly, 6 monthly, and yearly.
Payment amount: Payment amount is the amounts that need to be made to reach a particular future value. Continuing with example 1, if you don't have the necessary amount of savings, the payment amount will help you in determining how much you need to pay each month or each year to reach the amount of £30,000.
The concept of present value is also useful in calculating bond yields and pensions. It is also useful in comparing different investments. If an investor has a choice between two investments, present value can be of great help.
Example 1: Investment A is giving £15,000 in one year, and investment B is giving £1,250 per month for 12 months. Interest rate is 7% for both these investments. While it may seem like both investments are giving £15,000 in one year, the use of present value will help you determine which one is more profitable.
The investment, which gives £15,000 in 1 year has a present value of £14,018.69. And the investment that gives £1,250 every month for 12 months has a present value of £14,446.40. So you can see the second investment has a higher present value and therefore if you have a choice, you should choose the second investment.
Present value is a very important concept in finance and can be very useful in choosing among various investment options.
Our Present Value Calculator can be useful for calculating the present value under different scenarios.
You may also find the following Finance calculators useful.