Present value (PV) is one of the most fundamental financial concepts. It is the value of future cash payments (PMTs) expressed as if you received or spent the money today in a single lump sum.
You can use a financial calculator or spreadsheet to calculate the present value of a discounted cash flow, such as an annuity, based upon the timing and number of future payments. One common use of PV is to calculate the current price of a bond based upon its future payments of interest and the return of principal.
Consider Also: How to Calculate a Bond Price
The Discount Rate
At the heart of the present value calculation is the discount rate, which expresses the time value of money (TVM). Specifically, TVM is based upon the notion that a dollar in your pocket today is worth more than it would be if you received it at a future date. The reasons for this are:
1. You can spend the money today and not experience the effects of inflation, which robs money of its value over time.
2. You can invest the money today and earn a return, such as interest or dividends. In fact, interest is an expression of money’s time value, subject to various conditions.
The discount rate is the rate at which you deflate the value of future cash flows to equate to their present value. Another way to look at discount rate is as the amount of money you would need today to fund a series of future payments. A special discount rate is the risk-free rate, commonly equal to the interest rate on U.S. Treasury debt.
The Present Value Formula
The present value of an ordinary annuity (i.e., an annuity that pays interest at the end of each specified period) is as follows:
PV = PMT x ((1 – (1/(1+r)n)) / r)
PV = Present value of an annuity cash flow stream
PMT = Dollar amount of each annuity payment
r = Discount rate
n = Number of periods over which payments will be made
For example, suppose you were offered an annuity that paid $25,000 per year for 20 years and would cost you $300,000 to buy today. Is it a good deal? Assume that the risk-free interest rate, 5 percent, is used as the discount rate.
Plugging in the numbers, you get:
PV = $25,000 x ((1 – (1 / (1 + .05) 20)) / .05) = $311,555
In today’s dollars, the annuity is worth $11,555 more than the cost to buy it, making it the better choice.
Consider Also: Characteristics of an Annuity
Using PV Calculator With PMT
You can quickly calculate the present value of an annuity using a business calculator, such as the Hewlett-Packard 12C. The calculator has special buttons for the PV formula: To enter the variables, include “PMT” for payment, “i” for the discount rate and “n” for the number of payments. After entering the variables, press the PV button to get the annuity’s present value.
Consider Also: What Are the Benefits of a Financial Calculator?
Using an Excel Spreadsheet
You can calculate present value in an Excel spreadsheet by using the PV function. The variables you would enter are Rate (the discount rate), Nper (number of periods) and Pmt (payment amount).
The spreadsheet accepts an optional parameter – Type. If Type is set to 0 (the default), payments are due at the end of the period. You can set it to 1 for payments due at the beginning of the period.
By the way, when you calculate PV for an annuity, the answer is given as a negative number. The reasoning behind this is that the present value is the amount you would have to spend today to break even with the return on the annuity. Spending is a negative cash flow (i.e., the money is leaving your pocket), so the result is negative.
- This equation applies only to annuities with constant payments made at the end of each period.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.