Present Value Calculator
- Future Value (FV): The expected value of your investment or acquisition at the end of the specified period.
- Discount Rate (r): Measures the expected growth in your investment or acquisition over time. This can be expressed as either a percentage or an annualized value.
- Number of Years (t): How many years you would like to spread your investment or acquisition over time.
- Compounding Frequency (n): The number of times per year the value is compounded.
In the finance world, one of the most important concepts is present value. This calculation allows you to adjust sums of money over multiple years to compensate for risk, opportunity cost, and inflation within the United States. At its core, the theory believes a dollar received today is more valuable than a dollar received next year. That's because you can invest that dollar today and earn compound interest on it, whereas you can't do anything with the dollar you receive next year.
Businesses use present value to evaluate investments, calculate rates of return, and evaluate potential acquisitions. At the same time, individuals can use present value to evaluate retirement plans, determine how much they need to save each year, and decide whether it makes sense to pay off debt sooner.
On our present value calculator, you can enter any amount, the number of years that you'd like to spread it out over, and your desired rate of return. Our calculator will then provide you with an estimate of the present value of your investment or acquisition.
Tip: Time Value of Money Explained
The time value of money is all about the principle that a dollar received today is worth more than a dollar received tomorrow. Several different factors contribute to the time value of money, including interest rates, inflation, and risk.
Present Value Calculator Explained
The calculator is used to discount a lump-sum amount to the desired year. You can enter the amount you wish to discount, the years over which it will be discounted, and your expected rate of return. You can also decide the annual compounding frequency. Assuming everything remains constant, each input will affect the present value in the following way:
- Increasing future value increases present value since you start with a higher initial number.
- Increasing the discount rate decreases the present value because a higher expected return reduces the initial purchase price.
- Increasing the number of years decreases the present value because there are more discounting periods.
- Increasing the compounding frequency decreases present value because more discounting periods happen yearly.
Our calculator will then provide you with an estimate of the present value for that lump-sum amount in the desired year. This calculation is often used in business to evaluate investments and determine rates of return.
Example Present Value Calculation
Let's say you want to buy a home today and sell it for $1,000,000 in 10 years. In this scenario, you can use market data to determine the purchase price of your home. You can use your city's average annual real estate return as the discount rate. Let's assume these inputs:
- Future Value (FV): $1,000,000
- Discount Rate (r): 5.00%
- Number of Years (t): 10
- Compounding Frequency (n): 1
As a result, you can use the following formula to calculate the home purchase price today to ensure you end with a $1,000,000 home.
Present Value Calculation
= $1,000,000 / (1+0.05/1)^(10*1)
Based on this formula, the present value of your home purchase today is approximately $613,913.254. This figure represents the amount you need to buy your home today to achieve a $1,000,000 house in ten years.
Determining The Discount Rate
The most confusing part of using a present value calculator is deciding which discount rate to use. Higher discount rates imply more risk or a higher desired return. This is because a higher discount rate decreases the present value. When there is more risk, the buyer wishes to increase their expected return to compensate. However, there are a few standard methods for deciding a discount rate.
The risk-free rate is the interest rate you can earn on investments with virtually no risk.
For example, many consider US treasury bonds a risk-free investment since the US government backs them. As a result, it's the lowest discount rate used in present value calculations.
The risk-free rate should come from the bond yield of the same maturity date. For example, if you are calculating the present value ten years in the future, you should use a ten-year US government bond yield.
If your investment isn't completely risk-free, you should use an industry rate instead.
This rate is typically similar to the risk-free rate but with a small additional premium. For example, you might use the yield on ten-year government bonds plus 0.25% to account for some risk or opportunity cost associated with your investment.
Weighted Average Cost of Capital (WACC)
This is a company-specific discount rate that is derived from the corporate finance structure. It's typically used for making investment decisions that affect the overall value of a business.
WACC considers not only the risk-free rate but also the company's cost of debt and equity.
The cost of debt is determined by the interest rate or yield on debt instruments such as bonds or loans. The shareholder's expected return determines the cost of equity. This is similar to the risk-free rate but also considers the risk associated with equities, such as dividends and capital appreciation.
The Bottom Line
When using a present value calculator, you must consider the discount rate and your desired period. The higher these numbers, the lower the present value will be. However, it would help if you also considered other factors that may affect your investment decision, such as industry rates or WACC. With a bit of research and some trial and error, you should find the correct risk-adjusted present value.