The concept of present value is a simple one even though you may not be familiar with the term. If someone offers you $1,000 today or $1,000 in five years, you will probably choose to take the $1,000 today. You inherently understand that $1,000 today and $1,000 in five years are not the same thing. If, however, someone offers you more than $1,000 in five years, you might be tempted to wait. That is the concept of interest, and at some point the interest earned by waiting five years will be high enough that you would choose to wait. If the choice was between $1,000 today and $10,000 in five years, almost everyone would choose to wait five years.
The value of a dollar today is its present value (PV), and the value of a dollar in the future is its future value (FV). The difference between those two numbers is determined by an interest rate (I) and time (N).
Video of the Day
Present Value Formula and Example
PV = FV / (1+I) N
For example, suppose you will need $50,000 in 10 years to pay for college tuition. How much do you need to put into an account earning 8% annually today to achieve this goal? Substitute 50,000 for FV, 0.08 for I, and 10 for N into the PV equation.
PV = $50,000 / (1.08)10
PV = $23,160