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:
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
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:
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
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.