Present value of money

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The present value of money (PV) is the amount of money today that equals a (typically greater) amount of money at some moment in the future.

Interest and Inflation are the key parameters in calculating the present value of money.

The principle behind the present value of money is that a dollar today has the potential to be invested and return a profit over time, so that a dollar "in-hand" that can be invested today is worth more than a dollar promised to be paid in the future.

A simple example involving interest illustrates this concept. If you were offered $100 today or $105 a year from now, and the annual interest rate on a savings account was 8%, you would be better off taking the $100 now. That's because if invested, $100 today would be worth $108 a year from now.

Inflation is also a part of assessing the present value of money, because as costs rise a dollar buys less and less over time. If the inflation rate is 3%, each dollar not invested in an opportunity that returns at least 3% is losing value over time.

A complement to the present value of money is the future value of money (FV). The latter term is used in problems like "If I want to retire in 40 years with $1,000,000 in the bank, how much would I have to have in the bank today?" If the bank paid 5% annual interest, the answer is that an investment today with a Present Value of $142,045.69 would yield a Future Value of $1,000,000.05 in 40 years.

Another example of Present Value versus Future Value is found in state lotteries that offer a "cash option" for jackpot payouts. Large jackpots are typically paid out in installments over 20 years from an interest-bearing account, and the jackpot amount includes the interest that would have been earned over the 20 years. If a winner chooses to receive the payoff up front "in cash", then the amount they receive is lower than the stated jackpot, but has the same Present Value as the Future Value of the full jackpot 20 years from now. If the winnings are responsibly invested at a higher return than the bank account use by the lottery, then taking less money up front is the smart choice, because it's still the full Present Value of the prize.