Tuesday, April 17, 2007

How To Calculate Present Value

The concept of present value is rather simple. If I want $1000 by the end of 2 years and then interest rate is 10%, how much do I need to invest today? The answer is $826.

Today this is a pretty simple calculation. Just push the buttons on your calculator and done. But, what if you had to fiqure it out the "old-fashioned" way. Well here's the formula fiqure it out.

Present Value = Future Value/ (1 + Interest Rate)

For example, What would be the present value of $100 at 8% interest for 1 year?

Present Value = $100/(1 + .08)

Present Value = $100/1.08

Present Value = $92.59

Pretty simple, but what if you needed to fiqure it out for 3 years? Here's how to do that.

Year 1 Present Value = $100/1.08 = $92.59

Year 2 $92.59/1.08 = $85.73

Year 3 $85.73/1.08 = $79.38

So in three years, if we invest $79.38 today, we will have $100

Of course there are a couple of shorter ways to calculate present value. Here is a formula that uses exponents.

Another quick short cut is to use the present value interest tables. This chart is usually labeled as the PVIF table. The tables already have the (1 + interest rate) fiqured out for you. For example, 5% interest for 8 years gives us a factor of .677.

Take $100 x .677 to get $67.70 as the answer. Can't get any easier than that.

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