If you could choose between getting $500 now or getting $500 a year from now, most people would take the money now. This fundamental axiom involves the time value of money, and economists have sought ways to compare streams of money earned at different times in a way that takes time value into account. Below, you'll learn about three techniques that you can use in various situations to get the answers you're looking for.
Present value calculations
One common time-value problem deals with expecting a specified sum of money at a point in the future. Because money earned in the future is worth less than money earned now, you have to apply a discount to the future payment in order to get its equivalent present value. Often, the discount rate used is equal to the prevailing risk-free rate for assets like Treasury securities without default risk. The further into the future the payment is, the greater the discount.
The math behind a present value calculation is a bit complicated but can be done with a basic calculator. To come up with present value, take 1 and add it to the discount rate used. Then raise that number to the power of the number of years in the future that you'll receive the payment. Save the resulting figure, and then divide the future payment amount by that figure. The final result will be the present value.
For instance, say you know that you'll receive $110.25 in two years and decide that a discount rate of 5% is appropriate. In that case, 1 plus 5% equals 1.05, and 1.05 raised to the second power is 1.1025. Divide $110.25 by 1.1025, and you get $100, which is the present value.
Future value calculations
Future value calculations work in the opposite manner. You'll follow the same steps as you did for present value, adding 1 to the discount rate and then raising that number to the power of the number of years in the future that you're measuring the future value. But then, you'll need to multiply the result by the value of the current payment. The final result is the future value.
For instance, if you want to know the future value of $100 in two years assuming a rate of 5%, then 1 + 5% is 1.05, 1.05 raised to the second power is 1.1025, and $100 multiplied by 1.1025 is $110.25. As you can see, this matches up with the present value calculation above.
Recurring value techniques
The two methods discussed above work well for one-time payments, but other methods are better for recurring payments. You can always just calculate present or future value for each payment separately, but there are sometimes shortcuts available for common situations.
For instance, say you have an asset that pays a perpetual stream of income. You can't calculate each payment separately, but the equation for its present value turns out to be quite simple: take the amount of each regular payment and divide it by the discount rate. So if you receive $100 each year and use a discount rate of 5%, then its present value is $100 / 5% = $2,000.
Knowing how to deal with time-value problems can save a lot of time and make it easier to compare streams of future payments. That way, you can make smarter decisions about money.
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