Assuming you have $10,000 in your bank account today. Of course that is the present value of your money because it is exactly the amount you can spend at present. However, if you expect to be paid $10,000 in the next 1 year, the present value would be less than that. The present value of the future $10,000 is the amount that you need to invest today to receive $10,000 after one year.
Based on the illustration above, the present value of money refers to the current value of money that we expect to receive in future. In technical terms, the present value can be defined as the amount of money that is obtained by discounting the future value of cash flows. A discounting rate is the interest rate applied to future cash flows to determine their present value. It is used when appraising an investment project to determine whether it is viable or not.
How to Calculate the Present Value of Money
The present value of money is calculated using the future value; but the formula is the in the reverse. The PV is calculated by applying a discounting rate on the future cash flows or future payments. Essentially, you need to rearrange the formula for the future value by dividing rather than multiplying as shown below:
- PV = Present value (original amount of money)
- FV = Future value
- i = Interest rate per period
- n = Number of periods
Alternatively, the PV formula can be rearranged as follows:
PV = FV × (1+i)-n
For example, assume Mrs. Karanja expects to earn $40,000 as her retirement benefits after 15 years. Using a discounting rate of 5.5%, calculate the amount of money she needs to save today for her retirement.
PV = 40,000 × (1+0.055)-15 = 17,917.
In this regard, Mrs. Karanja needs to have a present value of $17,917 to put into a savings plan earning 5.5% over the next 15 years to get a future payment of $40,000