Pesent Value is defined as the total value TODAY of a FUTURE stream of payments.
One way to look at the PRESENT VALUE is to see it as "the lump sum amount that, when invested
today at a predetermined interest rate, will be just enough to make each and every future
payment." At the time the final payment is made, the entire lump sum would be spent.
As an example, imagine that you are purchasing a used car. The finance period is 5 years, and
you must pay the bank $2000 per year. How much money invested TODAY, earning an interest
rate of 5.0% per year, would make the payments for the finance period?
The answer: $9,92.
The total of the FUTURE PAYMENTS is 5 * $2,000 = $10,000. However, the PRESENT VALUE
of those payments is $9,092, because that amount, invested at 5% interest, will make all 5
payments of $2,000, and once the final payment is made, the money will be gone.
| Year
|
Investment
|
Payment
|
Remainder
|
Interest
|
Balance
|
| 1
|
$9,092
|
$2,000
|
$7,092
|
$355
|
$7,447
|
| 2
|
$7,447
|
$2,000
|
$5,447
|
$272
|
$5,719
|
| 3
|
$5,719 |
$2,000
|
$3,719 |
$185 |
$3,094 |
| 4
|
$3,094 |
$2,000
|
$1,904 |
$95 |
$2,000 |
| 5
|
$2,000 |
$2,000
|
0 |
0 |
0 |
|