Present value (PV) takes into account three main factors:
- The expected future value of the money or cash flows to be received.
- The interest rate or discount rate, which represents the rate of return that could be earned if the money were invested today.
- The number of periods (time) until the future cash flow is received.
PV is calculated by discounting the future value back to the present using the formula:
PV=FV(1+r)nPV=\frac{FV}{(1+r)^n}PV=(1+r)nFV
where FVFVFV is the future value, rrr is the discount rate (expressed as a decimal), and nnn is the number of periods
. This reflects the time value of money concept, which holds that a sum of money today is worth more than the same sum in the future because it can be invested to earn a return. The discount rate also accounts for risks such as inflation, default risk, and opportunity cost of capital
. In summary, present value takes the future amount, discounts it by the expected rate of return over the relevant time period, to determine what that future sum is worth in today's terms
