Date: 31/07/2016

Assignment On Present Value

'Present Value - PV'

Present value (PV) is the current worth of a future sum of money or stream of cash flows given a
specified rate of return. The present value of a future payment, or the time value of money, is
what money is worth now in relation to what you think it'll be worth in the future based on
expected earnings.
For example, if you have a 10% return, $1,000 is the present value of the $1,100 you expect to
have a year from now.
The concept of present value is useful in calculating how much you need to invest now in order
to meet a certain future goal, such as buying home or paying college tuition.
Many financial websites and personal investment handbooks provide calculators and other tools
to help you compute these amounts based on different rates of return.
Inflation has the opposite effect on the present value of money, accounting for loss of value
rather than increase in value. For example, in an economy with 5% annual inflation, $100 is the
present value of $95 next year.
Present value also refers to the current value of a securities portfolio. If you compare the present
value to the acquisition cost of the portfolio, you can determine its profit or loss.
Further, you can add the present value of each projected interest payment of a fixed income
security with one year or more duration to calculate the security's worth.
In other words, the amount of cash today that is equivalent in value to a payment, or to a stream
of payments, to be received in the future. To determine the present value, each future cash flow is
multiplied by a present value factor. For example, if the opportunity cost of funds is 10%, the
present value of $100 to be received in one year is $100 x [1/(1 + 0.10)] = $91.

HOW IT WORKS (EXAMPLE):

The formula for present value is:
PV = CF/(1+r)n
Where:
CF = cash flow in future period
r = the periodic rate of return or interest (also called the discount rate or the required rate
of return)
n = number of periods
Let's look at an example. Assume that you would like to put money in an account today to make
sure your child has enough money in 10 years to buy a car. If you would like to give your child
$10,000 in 10 years, and you know you can get 5% interest per year from a savings account
during that time, how much should you put in the account now? The present value formula tells
us:
PV = $10,000/ (1 + .05)10 = $6,139.13
Thus, $6,139.13 will be worth $10,000 in 10 years if you can earn 5% each year. In other words,
the present value of $10,000 in this scenario is $6,139.13.
It is important to note that the three most influential components of present value are time,
expected rate of return, and the size of the future cash flow. To account for inflation in the
calculation, investors should use the real interest rate (nominal interest rate - inflation rate). If
given enough time, small changes in these components can have significant effects.

Calculating With Present Value Table:

The formula for calculating the present value factor is:
P = (1 / (1 + k)n)
Where:
P = The present value factor
k = The interest rate
n = The number of periods over which payments are made

Example :
A city wants to issue $1,000,000 of non-interest-bearing bonds to be repaid $100,000 per year for
10 years. How much should investors be willing to pay for the bonds if they require a 10%
return on their investment?
$100,000 x 6.1446* = $614,460
*6.1446 is the present value of an annuity of $1 for 10 periods at 10% interest.
WHY IT MATTERS:
The concept of present value is one of the most fundamental and pervasive in the world
of finance. It is the basis for stock pricing, bond pricing, financial modeling, banking, insurance,
pension fund valuation, and even lottery payouts. It accounts for the fact that money we receive
today can be invested today to earn a return. In other words, present value accounts for the time
value of money.
In the stock world, calculating present value can be a complex, inexact process that
incorporates assumptions regarding short and long-term growth rates, capital expenditures, return
requirements, and many other factors. Naturally, such variables are impossible to predict with
perfect precision. Regardless, present value provides an estimate of what we should spend today
(e.g., what price we should pay) to have an investment worth a certain amount of money at a
specific point in the future -- this is the basic premise of the math behind most stock- and bondpricing models.
Present value calculations, and similarly future value calculations, are used to value
loans, mortgages, annuities, sinking funds, perpetuities, bonds, and more. These calculations are
used to make comparisons between cash flows that dont occur at simultaneous times,[1] since
time dates must be consistent in order to make comparisons between values. When deciding
between projects in which to invest, the choice can be made by comparing respective present
values of such projects by means of discounting the expected income streams at the
corresponding project interest rate, or rate of return. The project with the highest present value,
i.e. that is most valuable today, should be chosen.

PRESENT VALUE OF AN ANNUITY:

An annuity is a series of evenly spaced equal payments made for a certain amount of
time. There are two basic types of annuity known as ordinary annuity and annuity due.
The present value of an annuity is the amount which if invested at the start of first period
at the given rate of interest will equate the sum of the amount invested and the compound interest
earned on the investment with the product of number of the periodic payments and the face value
of each payment.

Ordinary annuity is one in which periodic payments are made at the end of each period.
Annuity due is the one in which periodic payments are made at the beginning of each period.

1 (1 + i)-n
PV of an Ordinary Annuity = R
i
1 (1 + i)-n
PV of an Annuity Due = R

(1 + i)
i

Where,
i is the interest rate per compounding period
n is the number of compounding periods
R is the fixed periodic payment.

CONCLUSION:
The concept of present value lies at the core of finance. Every time a business does
something that will result in a future payoff or a future obligation, it must calculate the present
value of the future cash inflow or outflow. Understanding the concept of the time value of money
is crucial, whether you are managing a Laundromat or a multimillion dollar corporation- or even
just balancing your checkbook.