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Present Value of Money: Meaning and Use

For a layman, the question what is the present value of money would sound like something irrelevant. Ask that question to someone not conversant with the meaning of the term and you are likely to be laughed at. After all, the present value of hundred dollars today is neither more nor less than hundred dollars.

However, present value of money has a different meaning in the world of finance and is among the most widely used calculations. In finance, present value of money is the present worth of a future sum or a stream of cash flows assuming a specified rate of return. It is often used to determine the viability of an investment that is to establish whether it is favorable or not. Finance experts also use it for establishing the best use of money.

For example, suppose you need $5,000 dollars after three years and want to know how much money you should put in at the present rate of interest being offered by your bank. Calculating the present value will help you arrive at the exact amount. Similarly, you can also calculate the amount of series of equal payments (annuity) you must make at equal intervals to arrive at the target amount of $5,000.

Calculating the present value of money is simple if you know the formula. There are four variables: present value (PV), target amount or future value (FV), interest rate (i) and number of years (n). PV is equal to FV divided by 1+i raised to the power of n.

Suppose, you are targeting $5,000 in three years and your bank is offering 4% interest. Using the above formula you will arrive at a figure of $4,445. (1+0.4) n equals 1.24864. 5,000 divided by 1.24864 equals 4,444.98.

Calculating the present value of money also helps in identifying opportunities for profitable investments. It is commonly used when the purchase price is below the intrinsic value of the asset. For example, in real estate the intrinsic value of an income yielding property is arrived at by finding the present value of the cash flows that will accrue in future.

An investor can use this intrinsic value and compare it with alternative investment opportunities with similar risks to decide on which offers better return on investment. However, while using the present value approach for determining the intrinsic value of an investment, investors must necessarily view it in relation with the replacement value.



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