Present value or future value

Congratulations!!! You have won a cash prize! You have two payment options: A - Receive
$10,000 now OR B - Receive $10,000 in three years. Which option would you choose?

What Is Time Value?
If you're like most people, you would choose to receive the $10,000 now. After all, three
years is a long time to wait. Why would any rational person defer payment into the future
when he or she could have the same amount of money now? For most of us, taking the
money in the present is just plain instinctive. So at the most basic level, the time value of
money demonstrates that, all things being equal, it is better to have money now rather than
later.

But why is this? A $100 bill has the same value as a $100 bill one year from now, doesn't it?
Actually, although the bill is the same, you can do much more with the money if you have it
now because over time you can earn more interest on your money.

Back to our example: by receiving $10,000 today, you are poised to increase the future
value of your money by investing and gaining interest over a period of time. For Option B,
you don't have time on your side, and the payment received in three years would be your
future value. To illustrate, we have provided a timeline:

If you are choosing Option A, your future value will be $10,000 plus any interest acquired
over the three years. The future value for Option B, on the other hand, would only be
$10,000. So how can you calculate exactly how much more Option A is worth, compared to
Option B? Let's take a look.

SEE: Internal Rate Of Return: An Inside Look

Future Value Basics
If you choose Option A and invest the total amount at a simple annual rate of 4.5%, the
future value of your investment at the end of the first year is $10,450, which of course is
calculated by multiplying the principal amount of $10,000 by the interest rate of 4.5% and
then adding the interest gained to the principal amount:

Future value of investment at end of first year:
= ($10,000 x 0.045) + $10,000
= $10,450

You can also calculate the total amount of a one-year investment with a simple
manipulation of the above equation:

Original equation: ($10,000 x 0.045) + $10,000 = $10,450

Manipulation: $10,000 x [(1 x 0.045) + 1] = $10,450
Final equation: $10,000 x (0.045 + 1) = $10,450

The manipulated equation above is simply a removal of the like-variable $10,000 (the
principal amount) by dividing the entire original equation by $10,000.

If the $10,450 left in your investment account at the end of the first year is left untouched
and you invested it at 4.5% for another year, how much would you have? To calculate this,
you would take the $10,450 and multiply it again by 1.045 (0.045 +1). At the end of two
years, you would have $10,920:

Future value of investment at end of second year:
= $10,450 x (1+0.045)
= $10,920.25

The above calculation, then, is equivalent to the following equation:

Future Value = $10,000 x (1+0.045) x (1+0.045)

Think back to math class and the rule of exponents, which states that the multiplication of
like terms is equivalent to adding their exponents. In the above equation, the two like terms
are (1+0.045), and the exponent on each is equal to 1. Therefore, the equation can be
represented as the following:

We can see that the exponent is equal to the number of years for which the money is
earning interest in an investment. So, the equation for calculating the three-year future
value of the investment would look like this:

This calculation shows us that we don't need to calculate the future value after the first
year, then the second year, then the third year, and so on. If you know how many years
you would like to hold a present amount of money in an investment, the future value of that
amount is calculated by the following equation:

SEE:Accelerating Returns With Continuous Compounding

Present Value Basics
If you received $10,000 today, the present value would of course be $10,000 because
present value is what your investment gives you now if you were to spend it today. If
$10,000 were to be received in a year, the present value of the amount would not be
$10,000 because you do not have it in your hand now, in the present. To find the present
value of the $10,000 you will receive in the future, you need to pretend that the $10,000 is
the total future value of an amount that you invested today. In other words, to find the
present value of the future $10,000, we need to find out how much we would have to invest
today in order to receive that $10,000 in the future.

To calculate present value, or the amount that we would have to invest today, you must
subtract the (hypothetical) accumulated interest from the $10,000. To achieve this, we can
discount the future payment amount ($10,000) by the interest rate for the period. In
essence, all you are doing is rearranging the future value equation above so that you may
solve for P. The above future value equation can be rewritten by replacing the P variable
with present value (PV) and manipulated as follows:

Let's walk backwards from the $10,000 offered in Option B. Remember, the $10,000 to be
received in three years is really the same as the future value of an investment. If today we
were at the two-year mark, we would discount the payment back one year. At the two-year
mark, the present value of the $10,000 to be received in one year is represented as the
following:

Present value of future payment of $10,000 at end of year
two:

Note that if today we were at the one-year mark, the above $9,569.38 would be considered
the future value of our investment one year from now.

Continuing on, at the end of the first year we would be expecting to receive the payment of
$10,000 in two years. At an interest rate of 4.5%, the calculation for the present value of a
$10,000 payment expected in two years would be the following:

Present value of $10,000 in one year:

Of course, because of the rule of exponents, we don't have to calculate the future value of
the investment every year counting back from the $10,000 investment at the third year. We
could put the equation more concisely and use the $10,000 as FV. So, here is how you can
calculate today's present value of the $10,000 expected from a three-year investment
earning 4.5%:

So the present value of a future payment of $10,000 is worth $8,762.97 today if interest
rates are 4.5% per year. In other words, choosing Option B is like taking $8,762.97 now
and then investing it for three years. The equations above illustrate that Option A is better
not only because it offers you money right now but because it offers you $1,237.03
($10,000 - $8,762.97) more in cash! Furthermore, if you invest the $10,000 that you
receive from Option A, your choice gives you a future value that is $1,411.66 ($11,411.66 -
$10,000) greater than the future value of Option B.

SEE: Economics And The Time Value Of Money

Present Value of a Future Payment
Let's add a little spice to our investment knowledge. What if the payment in three years is
more than the amount you'd receive today? Say you could receive either $15,000 today or
$18,000 in four years. Which would you choose? The decision is now more difficult. If you
choose to receive $15,000 today and invest the entire amount, you may actually end up
with an amount of cash in four years that is less than $18,000. You could find the future
value of $15,000, but since we are always living in the present, let's find the present value
of $18,000 if interest rates are currently 4%. Remember that the equation for present value
is the following:

In the equation above, all we are doing is discounting the future value of an investment.
Using the numbers above, the present value of an $18,000 payment in four years would be
calculated as the following:

Present Value

From the above calculation we now know our choice is between receiving $15,000 or
$15,386.48 today. Of course we should choose to postpone payment for four years!

The Bottom Line
These calculations demonstrate that time literally is money - the value of the money you
have now is not the same as it will be in the future and vice versa. So, it is important to
know how to calculate the time value of money so that you can distinguish between the
worth of investments that offer you returns at different times.

Read more: http://www.investopedia.com/articles/03/082703.asp#ixzz23o2YcQri

Present value or future value

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Present value or future value