How to Calculate the Present Value of Future Salary Payments

Image Credit: NA/AbleStock.com/Getty Images

Frequently, the question arises of how to value deferred salary payments, or salary received in the future as opposed to immediately. Later payments lose some of their value because they cannot be invested or earn interest until they are received. The process of devaluing postponed payments is called discounting, and the factor by which they are discounted is the current rate of interest.

Step 1

Determine the amount of the payment you'll receive and when you'll receive it. Call the payment "P" and the number of years until you receive it "n."

Step 2

Determine the rates of interest for each year in which you'll be deferring the payment. The interest in year "j" will be i(j).

Step 3

Calculate the value (V) of your future salary payment by discounting for each year that elapses before it's paid. Use this formula:

V = P[1/[1+i(1)] + 1/[1+i(2)] + …+ 1/[1+i(n)]].

If the interest rate i remains constant, this equation reduces to V = P/(1+i)^n, where "n" is the number of years before the salary is paid.

For example, a payment of $10,000 deferred for three years, where the interest rate in year 1 is 4 percent, the interest rate in year 2 is 5 percent and the interest rate in year three is 6 percent, is 10,000/(1.04)(1.05)(1.06) = $8,639.16, while its value if the interest rate is constant at 5 percent is 10,000/(1.05)3 = $8,638.38.

references