The Economy & You #55 – When is $1 Million Only $623,000?
The concept of present value teaches us that money paid in the future is not the same as money paid today. In short, present value is what a dollar tomorrow is worth today. In the example I just gave, most million dollar prizes are paid out over time. In this case, we will say 20 years. To calculate the present value of one million dollars paid out as $50,000 over 20 years, we would use the following formula: PV = X/(1 + r)t where PV is the present value, X is the amount of money paid, r is the interest rate and t is the number of years.
If a person won a million dollars to be paid out in $50,000 payments over 20 years and the interest rate was 5%, the present value of that one million dollars would equal $623,110.52! A far cry from a million dollars.
The concept of present value is frequently used in financial decision making. Businesses calculate present and future value to decide whether or not to invest money in capital projects and business development initiatives. Utilizing present value provides you with the knowledge in making decisions between current resources and future gains.
Present value helps to determine the future interest earned on deposits over time, it determines whether to take a payment now or at some time in the future, and it determines how much money would be needed today (given a specific interest rate) to attain a specific dollar amount in the future.
In the world of corporate finance, the value of money is always changing because of the changing nature of inflation and interest rates. Present value is used as a standard of comparison to make those financial decisions. This same principle can be used when deciding on purchasing an annuity, or taking out a loan. In short, the concept of present value allows us to make better financial decisions.
- Financial Math Basics You Need to Know (wisebread.com)
- Understanding “Present” Value (sustainableengineeringsystems.com)