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Chapter 3. Working with Basic Financial ... > Using the Present Value Function

Using the Present Value Function

Present value is similar to future value in that it represents the value of an investment. However, it calculates the value of money you will receive in the future from the perspective of right now. A dollar today is always worth more than a dollar tomorrow because of the interest you can earn on today’s dollar. This might not make sense right off, so let’s look at a couple of examples.

For instance, suppose you know that you will need $10,000 in five years and you want to put a chunk of money away and let it earn interest to meet that goal. You know you can get a reliable 4% return. How much money do you have to put away now for it to grow to $10,000 in five years?

Here’s another example. Suppose your employer gives you a choice of how to take your annual bonus—either $2,300 in a lump sum now or $200 a month for the next 12 months. You could use a present value calculation to determine the present value of that $200 per month, compare it to the lump sum payment and make your decision accordingly. Simply multiplying $200 per month for a year gives you $2,400, but you cannot say that is better than $2,300 today due to interest you might earn over the next year on today’s $2,300.

As another example, you are looking to buy a new car and have decided that you can afford $290 per month payment for the next five years. Knowing the interest rate available on auto loans, you can use present value to determine the amount you will be able to borrow.

A more intuitive way to look at present value is this. Suppose you invest $X per month at Y% interest. The present value is the lump sum you would have to invest at the same rate to end up with the same total at the end of 12 months.

You use the PV function to calculate present value. The syntax is

PV(rate, nper, pmt, [fv, type])

The first three arguments are required:

  • rate is the interest rate per period.

  • nper is the number of periods.

  • pmt is the payment per period.

The other two arguments are optional:

  • fv is the future value, the balance at the end of the term, which is 0 in almost all situations. If omitted, the function assumes 0.

  • type is 1 if the payments are made at the start of each period, 0 or omitted if payments are made at the end of each period.

To try out the PV function, start with a blank worksheet and follow these steps:

Enter the labels Rate of return, Monthly payment, Number of months, and Present value in cells B2 through B5, in order.

Format cell C2 as percentage with two decimal places.

Format cells C3 and C5 as currency with two decimal places.

Enter the following formula in cell C5: =PV(C2/12,C4,C3).

As before, the monthly payment is entered as a negative value.

The worksheet shown in Figure 3.5 shows an example of evaluating the present value of $200 per month over 12 months assuming a 4% return. Returning to the example presented earlier, where you are offered this $200 per month or a lump sum of $2,300, you can see that the present value of these payments, assuming a 4% return, is $2,348.80. This tells you that the monthly payments are a better deal than the lump sum. If the interest rate were higher, you would see that the PV increases. Of course, if you need the money right away, that is another matter!

Figure 3.5. Using the PV function to calculate the present value of a series of payments.

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