What is present value
Present value is simply put, the value today of a future payment or payments. The value is adjusted to reflect the risk of such an investment (the interest rate you expect to get) and number of years until you expect to receive the payment. It is used to, simply put, decide if an investment payoff in the future is worth what is required as an investment today.
For instance, would you invest $1 today to get $1,000,000 a week from now? Now, I don’t need a calculator to tell you the answer to that. But, what about investing $1,000 now for a payoff of $2000 10 years from now? That is where present value calculations come in handy. That is approximately a 7% rate of return. Is that enough of a return for the risk involved? For instance, if one can borrow money at 4%, and invest at 7% with little risk, that is a no brainer. The trick comes when the risk increases.
Many investments are far from certain. That is why companies often require higher risk premiums, or interest rates to compensate for the unknown. For instance, would you loan your Uncle that has been in and out of the pen for the last 20 years your last 50 bucks. Better get a great rate of return on that one (and a lot of collateral).
This is where the human factor comes in. What are you willing to take in return for risk? You have to decide what is your risk tolerance and what you are willing to get in return. Investors want the most reward for the least risk, while borrowers want the same, just inverse interest rate wise. You have to find a happy medium based on how much you can expect to loose. If it is Vegas money, sure, go for the risky 20% sub prime mortgage, knowing that you can and probably will, loose. But, for most investors, earning 2 to 3 percent more than the money they borrow and having little risk makes the most sense. This is what banks do, and they are not stupid, despite what has been happening recently.
Present value can also be applied to time and hypothetical situations. Before I went to college, I figured out how much I would spend on college over the many years, how much time I had to give up, and how much more I would earn in the future. It was not worth it based on these calculations, but I went anyway just because I wanted to. It was a fun exercise to figure out anyway.
To find present value, get a Texas Instruments financial calculator, as it is much easier (and cheaper) than the HP to use. After you have figured out how to set it up, then you can put n for the number of periods of your investment, I is for interest, PV is the present value, and FV is for future value. These are all you need for the basic calculations. If you enter any 3 of these and press CPT and the 4th one, it will tell you what the 4th is. For instance. If you want to find what your invest today will be worth in 5 years, put in you present investment in PV, your number of years in N and your interest rate in I/Y, and hit CPT and FV. That will be what your investment will be worth.
These are the only 4 buttons most people need as most just need to know what an investment today will be worth in X years or what interest rate one needs to get to turn $1 into $20 by retirement. Just imagine how much work people had to do before calculators. Now, with a couple small clicks, you can figure out complex financial issues.
