Because of its ability to earn interest, dividends and other returns, a payment you receive today is inherently more valuable than a payment received in the future. Because of the time value of money, the best way to judge an ongoing payment is to discount it back to today's dollars. This is referred to as the present value of the investment. The way you calculate the present value of the ongoing payment depends on whether it's a perpetuity or part of a different set of ongoing payments.
Information Needed for Present Value Calculations
You'll need the following information to calculate present values:
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- Frequency of the payments
- Amount of each individual payment
- Original cost of the investment
- Discount rate (also known as the interest rate)
The discount rate is the rate of return you would earn on an investment that has a similar risk level. A common benchmark is the yield rates on U.S. treasury bonds.
Present Value of a Perpetuity
Some investments offer you an infinite series of ongoing payments. These investments are referred to as perpetuities. To be a perpetuity, the payment must always be in the same amount and you must receive the payment in consistent intervals. For example, an ongoing payment of $100 once a year with no stopping point is a perpetuity.
To calculate the present value of a perpetuity, divide the amount of the payment by the discount rate. For example, if you receive $1,000 a year and the discount rate is 2 percent, the present value of the perpetuity is 1,000 divided by 0.02, or $50,000.
Assuming that the cost and the payment amount from the perpetuity is the same, a higher discount rate will result in a lower present value. That's because when you have the opportunity to earn a high rate of return elsewhere, the opportunity cost of investing cash in the perpetuity is higher and the present value of the investment is lower.
Present Value of Other Ongoing Payments
If you have an ongoing payment that's irregular in some fashion, or has a designated end point, you need to use a more complex formula to calculate present value. To calculate the present value of an ongoing payment, you need to calculate the individual present values of each cash outflow and inflow and add them together.
Present Value of Individual Cash Flows
Use the following formula to calculate the present value of a cash flow:
PV = CF/(1+r)n
Where PV is present value, CF is the amount of the cash flow, r is the discount rate and n is the number of periods.
For example, say your first payment will be $1,000 in one year and the discount rate is 2 percent. The present value of the first cash flow is $1,000 divided by 1.02, or $980. If you'll receive another $1,000 cash flow in year two, the present value is $1,000 divided by 1.04, or $962. Repeat this process for each cash flow you'll receive.
Net Present Value of the Ongoing Payments
Once you've found the present value of all the cash flows, sum them to find the net present value of the cash flow. For example, say that your investment would cost $500 and you calculate that you'll receive payments with the present value of $980 and $962. The net present value is $980 plus $962 less the original $500 outset, or $1,442.