Present Value

The present value of money is relative to its future value considering the interest rate and the length of time in which it has to be paid. The present value of an amount of money becomes less the longer it takes for the amount to be paid. The difference between the present value and the future value of an amount of money is affected by the number of compounding periods that come in between the two.

As an example, consider investing an amount of money at a financial institution that gives a rate of return of six percent compounded annually. If you would like to get $150,000 in five years, how much would you have to invest today? Your investment accounts for the present value of the money while $150,000 is the future value of the money in five years.

To compute for the example, the formula PV = FV [ 1 / (1 + i)n ] is used. PV is the present value of the money. FV is the future value, i is the interest rate and n is the number of compounding period. To replaced the variables in the computation, the formula would be PV = $150,000 [ 1 / (1 + .06)5 ]. This would give a present value of $112,088.73, which you have to invest today.

During the first year of your investment, this amount would earn $6725.32. Adding the interest to the principal, you total investment for the next year would be $118,814.05. This would then earn an amount of $7,128.24 for the second year. And by the end of the fifth year, your $112,088.73 will be $150,000.