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What is “Present Value?” – Part 1

By JLP | May 27, 2006

If you are familiar with personal finance, you have probably heard the term “present value” mentioned a time or two. Have you ever wondered what it means? The best way to define present value is with an example.

Let’s say your uncle Bob had happy thoughts towards you and he left you $1,000,000 when he went on to the happy place (in other words, he died!). You are happy that he left you the money but for some reason (maybe he didn’t want you touching it or something) you can’t get the money for 5 years. However, let’s say that it is possible for you to “sell” your $1 million. In other words, someone is willing to buy your $1 million today. You get money today and they get your $1 million in five years. The question is:

DEAL OR NO DEAL?

Ooops! Wrong show. Sorry, I just had to throw that in there.

The real question is:

What is your $1 million worth TODAY? In other words: what is the PRESENT VALUE of $1 million DUE five years from now?

It should be clear to you by now that a buyer wouldn’t want to pay you $1,000,000 in order to get $1,000,000 five years from now. Why? Because of inflation! One great truth (or law) of finance is that

A dollar TODAY is worth more than a dollar in the future.

If inflation is running 3% a year, each year, that $1 million loses approximately $30,000 of its purchasing power. Based on those numbers, that $1 million would be worth $858,734 in five years. Here’s how I figured that:

Future Value = Present Value * (1 + ROR)n

ROR is the rate of return, which is -3% or -.03 since we are talking about inflation which TAKES AWAY

n is the number of years, which is 5

* is the multiplication sign

Future Value = $1,000,000 * (1 + -.03)5

Future Value = $1,000,000 * (.97)5

Future Value = $1,000,000 * .858734

Future Value = $858,734

So, from your point of view, if someone were to offer you $858,734 TODAY or $1,000,000 in five years and inflation was expected to run 3% per year, you would be indifferent. From the buyer’s point of view, they clearly would not want to give you $1,000,000 today for the promise of getting $1,000,000 five years from now.

Okay, there we have the first part of this puzzle. Next time I will hopefully make the puzzle clear. It’s late and I need to some sleep.

Topics: Financial Math Basics | 2 Comments »


2 Responses to “What is “Present Value?” – Part 1”

  1. Hubert Miles Says:
    May 28th, 2006 at 7:31 pm

    Great explanation of Present Value and how it works. This is why I have never understood why people who win the lottery take an upfront reduced lump sum payout rather than yearly installments.

    At our website we provide a Present Value Calculator that your readers may find of interest. It can help with the calculations.

  2. Mighty Bargain Hunter » Roundup for week of 28 May 2006 Says:
    June 2nd, 2006 at 12:12 am

    […] AllFinancialMatters explains present value.  (Caution:  Math alert!) […]

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