Present Value

Money in the future is worth less than money today, because money today can be invested. Present value answers the question: how much would I need to invest today to end up with a particular amount later?

Suppose you will receive 10,000 in five years and you could earn 5% a year elsewhere. The present value of that 10,000 is about 7,835. If you invested 7,835 today at 5% a year, it would grow to 10,000 in five years. So, to you, the promise of 10,000 later is worth about 7,835 now.

This process of shrinking a future amount back to today is called discounting, and the rate used is called the discount rate. A higher discount rate or a longer wait makes the present value smaller. At 8% instead of 5%, the same 10,000 in five years would be worth only about 6,806 today.

Present value lets you compare money received at different times on an equal footing. It is used to price bonds, value businesses, compare loan offers and decide whether an investment is worth its cost.