The term present value denotes the value which future payments or income streams would be worth at the present.
Understanding the present value helps you compare a set of outgoing or incoming payments which occur at different points in time based on a given interest rate: The higher the present value, the higher the cost or value of future payments.
You can find the present value of a payment which will occur in n years based on an annual interest rate and compounding interest using the formula 1 / (1 + (interest rate as a %) / 100)n. This process is known as discounting, and for this reason the term discounted value is sometimes used synonymously with present value.
Present value accounts for the actual cash value of assets: The earlier an incoming payment is received, the higher the value of that payment is – when interest rates are positive. Because of this, the interest rate which applies to future payments is a deciding factor in the calculation of present value.
When assets which make up future payments earn interest at a high rate, the value of the payment at the time that it is paid out in the future is higher than its present value thanks to the high returns. When a 0 percent interest rate applies to future payments, the value of the future payment is identical to its present value. When a negative interest rate applies, the present value is higher than the actual value of the payment at the future point at which it is paid out.
The present value of an income stream can be calculated by adding the present value of each individual incoming payment. The present value of a recurring outgoing payment can be found by subtracting the present value of each individual outgoing payment.
Example of a present value calculation
An individual will receive a payment of 1000 Swiss francs after a 10-year investment term. The capital earns interest at the rate of 10% until it is paid out. The present value in this case would be: Present value = CHF 1000 / (1 + 10/100)10 = CHF 385.55.
At a 10% interest rate, the present value of the payment would be 385.55 francs because if the individual were to invest the 385.55 francs over a 10-year term at an interest rate of 10%, they would have 1000 francs after 10 years (385.55 francs principal plus 614.45 francs interest).
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