What Is Present Value?

157

What is the Present Value? Many investors will often ask this question when they are considering borrowing money for investment purposes. Present value is an important concept that should not be overlooked when you are thinking about using financial tools such as bonds or mutual funds for investing.

What is the Present Value? Present value indicates that an amount of cash in the past is valued at an amount in the future today. It is defined as the amount of cash a stock, bond or mutual fund is presently worth less than what it would cost to purchase or sell it at the present time. Simply put, the future value (pv) describes how much money a stock, bond or mutual fund will eventually be worth in the future. The discount rate indicates how fast money can be borrowed and how much interest can be paid over time.

How Do You Define Present Value? Present value (pv) is commonly defined in terms of expected cash flows over a period of time. The discount rate is used to describe how fast cash can be borrowed and how much interest can be paid over that period of time. While there are a number of formulas and estimates that can be used to calculate what is the present value, they typically rely on information that is usually very difficult to obtain.

There are two primary ways to calculate what is the present value, and these are discounted cash flow and future value. A discounted cash flow (sometimes called delta-closure) describes the amount of cash that is currently available to a borrower based on interest rates and other economic conditions over a specified period of time. Future value describes the amount of cash that will be available to an investor based on future investment results. Both types of calculation are important for investors who must choose between the different payment terms of a loan.

Investors must calculate present values of cash flows in a variety of circumstances. Typically, they must assess the current discount rate, future payment rates and other economic factors such as inflation and interest rates. They also need to determine the risk of lending based on their capital structure. This includes determining if a company’s credit ratings are good enough to allow for safe and favorable loans. In most cases, investors must rely on other sources such as current company news, analysts’ opinions and bank statements in order to determine what is currently marketable.

The discount rate is the primary economic factor used by investors in present value calculations. It can be calculated by dividing the total amount of investment money already committed to a project by the expected amount that would be invested at a specific discount rate. The larger the discount rate, the more investment dollars would be required for the total amount to be invested. Because of this, it is often used as the first step in evaluating potential investments.

The final economic factor used in present value and future value calculations is interest rate. Typically, the longer the time period considered in a calculation, the lower the interest rate will be. As such, if a lender is willing to lend money at a discount rate for an extended period of time, then the amount of investment capital available for the total loan amount will be substantially higher. The time period also determines how long the expected interest rate on the loan will last. Thus, it is necessary to evaluate the duration of the proposed investment in order to determine the fv of the loan.

The final present value calculation can be done using one of several formulas. These formulas are based on the assumption that all future cash flows will eventually return to their original values. Specifically, they assume that the present value of each dollar borrowed will equal the sum of future cash flows discounted to the present. While this might seem theoretically possible, the real world tends to be far from ideal. Interest rates tend to change dramatically from time to time and the amount an investor invests will ultimately vary depending on what is happening in the economy. Regardless, these present value formulas can help investors focus on the most critical aspects of their investments, which is their overall profitability.