4.4 Present Value    

For many investment decisions, it is necessary to find the principal, or present value, that corresponds to a given future value.

Example 4.4.1

Consider a note that will pay $10,000 to whoever owns it three years from now. If an investor wants to earn 10% compounded annually, what is the most he or she should pay for the note?

 

You have:

  • i=10%=0.10 per year
  • n=3 years
  • FV= $10,000

Thus, using the compound-interest formula:

[latex]\begin{align*} &PV(1+i)^n=FV\\ &PV(1.10)^3=$10,000\\ &PV=\frac{$10,000}{1.1^3} =$7,513.15\\ \end{align*}[/latex]

 

This result can be checked by accumulating the money in an account, as shown in the next box.

Time Interest Balance
0 $7,513.15
1 $751.32 8,264.46
2 826.45 9,090.91
3 909.09 10,000.00

Formula for Present Value

The compound-interest formula can be rewritten to give the present value directly. Divide both sides of the equation by [latex](1+i)^n[/latex]

[latex]\frac{PV(1+i)^n}{(1+i)^n}=\frac{FV}{(1+i)^n}[/latex]

Cancel and rewrite:

[latex]PV = \frac{FV}{(1+i)^n}[/latex]

 

Knowledge Check 4.3

Find the present values by using the formula for PV given above.

 

  1. The present value of $5,849.29 due in two years if interest is at 8% compounded semi-annually.
  2. The present value of $8,998.91 due in nine months if interest is at 16% compounded quarterly.
  3. The principal of a loan that would amount to $50,000 in six years at 8.5% compounded annually.

Solutions at the end of the chapter

 

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