
Time Value Of Money  Present Value And Discounting
Present value, also called "discounted value," is the current worth of a future sum of money or stream of cash flow given a specified rate of return. Future cash flows are discounted at the discount rate; the higher the discount rate, the lower the present value of the future cash flows. Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they are earnings or obligations.
If you received $10,000 today, the present value would be $10,000 because present value is what your investment gives you if you were to spend it today. If you received $10,000 in a year, the present value of the amount would not be $10,000 because you do not have it in your hand now, in the present. To find the present value of the $10,000 you will receive in the future, you need to pretend that the $10,000 is the total future value of an amount that you invested today. In other words, to find the present value of the future $10,000, we need to find out how much we would have to invest today in order to receive that $10,000 in the future.
To calculate present value, or the amount that we would have to invest today, you must subtract the (hypothetical) accumulated interest from the $10,000. To achieve this, we can discount the future payment amount ($10,000) by the interest rate for the period. In essence, all you are doing is rearranging the future value equation above so that you may solve for P. The above future value equation can be rewritten by replacing the P variable with present value (PV) and manipulating the equation as follows:
Let's walk backwards from the $10,000 offered in Option B. Remember, the $10,000 to be received in three years is really the same as the future value of an investment. If today we were at the twoyear mark, we would discount the payment back one year. At the twoyear mark, the present value of the $10,000 to be received in one year is represented as the following:
Present value of future payment of $10,000 at end of year two: 
Note that if we were at the oneyear mark today, the above $9,569.38 would be considered the future value of our investment one year from now.
At the end of the first year we would be expecting to receive the payment of $10,000 in two years. At an interest rate of 4.5%, the calculation for the present value of a $10,000 payment expected in two years would be the following:
Present value of $10,000 in one year: 
Of course, because of the rule of exponents, we don't have to calculate the future value of the investment every year counting back from the $10,000 investment at the third year. We could put the equation more concisely and use the $10,000 as the future value. So, here is how you can calculate today's present value of the $10,000 expected from a threeyear investment earning 4.5%:
The present value of a future payment of $10,000 is worth $8,762.97 today if interest rates are 4.5% per year. In other words, choosing Option B is like taking $8,762.97 now and then investing it for three years. The equations above illustrate that Option A is better not only because it offers you money right now but because it offers you $1,237.03 ($10,000  $8,762.97) more in cash! Furthermore, if you invest the $10,000 that you receive from Option A, your choice gives you a future value that is $1,411.66 ($11,411.66  $10,000) greater than the future value of Option B.
Present Value of a Future Payment
Let's add a little spice to our investment knowledge. What if the payment in three years is more than the amount you'd receive today? Say you could receive either $15,000 today or $18,000 in four years. Which would you choose? The decision is now more difficult. If you choose to receive $15,000 today and invest the entire amount, you may actually end up with an amount of cash in four years that is less than $18,000. You could find the future value of $15,000, but since we are always living in the present, let's find the present value of $18,000 if interest rates are currently 4%. Remember that the equation for present value is the following:
In the equation above, all we are doing is discounting the future value of an investment. Using the numbers above, the present value of an $18,000 payment in four years would be calculated as the following:
Present Value 
From the above calculation we now know our choice is between receiving $15,000 or $15,386.48 today. Of course we should choose to postpone payment for four years! (For related reading, see Anything But Ordinary: Calculating The Present And Future Value Of Annuities.)
These calculations demonstrate that time literally is money  the value of the money you have now is not the same as it will be in the future and vice versa. It is important to know how to calculate the time value of money so that you can distinguish between the worth of investments that offer you returns at different times.


Investing Basics
What's Current Portion of LongTerm Debt?
The current portion of longterm debt is the part of a company’s longterm debt that must be repaid within the next year. 
Economics
Explaining Cost Control
For a business, cost control entails managing and reducing expenses. 
Fundamental Analysis
Explaining the Central Limit Theorem
Central limit theorem is a fundamental concept in probability theory. 
Fundamental Analysis
Examining Mexico's TrillionDollar GDP
Examining the gross domestic product growth and composition of Mexico, the second largest economy in Latin America 
Economics
Explaining Accounting Conservatism
Accounting conservatism is a principal that requires accounting rules be applied with high degrees of verification. 
Fundamental Analysis
What Causes Inflation in the United States
Inflation is the main catalyst behind U.S monetary policy. But what causes this phenomenon of sustained rising prices? Read on to find out. 
Term
What are NonGAAP Earnings?
NonGAAP earnings are a company’s earnings that are not reported according to Generally Accepted Accounting Principles. 
Fundamental Analysis
Calculating Return on Net Assets
Return on net assets measures a company’s financial performance. 
Economics
Understanding Cost of Revenue
The cost of revenue is the total costs a business incurs to manufacture and deliver a product or service. 
Economics
Explaining Carrying Cost of Inventory
The carrying cost of inventory is the cost a business pays for holding goods in stock.

Operating Cost
Expenses associated with the maintenance and administration of ... 
Trade Credit
An agreement where a customer can purchase goods on account (without ... 
Normal Profit
An economic condition occurring when the difference between a ... 
Cost Accounting
A type of accounting process that aims to capture a company's ... 
ZeroSum Game
A situation in which one person’s gain is equivalent to another’s ... 
Supply
A fundamental economic concept that describes the total amount ...

What should I study in school to prepare for a career in corporate finance?
Depending on which area you want to specialize in, corporate finance can be one of the most competitive fields in business. ... Read Full Answer >> 
Why would a company issue preference shares instead of common shares?
Preference shares, or preferred stock, act as a hybrid between common shares and bond issues. As with any produced good or ... Read Full Answer >> 
What is the difference between cost of debt capital and cost of equity?
In corporate finance, capital – the money a business uses to fund operations – comes from two sources: debt and equity. While ... Read Full Answer >> 
What is the difference between gross profit, operating profit and net income?
The terms profit and income are often used interchangeably in daytoday life. In corporate finance, however, these terms ... Read Full Answer >> 
How do dividends affect the balance sheet?
Dividends paid in cash affect a company's balance sheet by decreasing the company's cash account on the asset side and decreasing ... Read Full Answer >> 
Are dividends considered an expense?
Cash or stock dividends distributed to shareholders are not considered an expense on a company's income statement. Stock ... Read Full Answer >>