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Calculating the present value of an investment enables you to answer this question: how much is a proposed investment worth in today's dollars? You can answer that question using the PV or Present Value function. The PV function has five arguments Rate, NPER, PMT, FV, and Type. Rate is the discount rate, which I'll explain in a moment. NPER is the number of periods. PMT or payment is the amount of money deposited into the investment each period.
In other words, if you have a one year investment and you make monthly contributions of $1,000, that would be the PMT value. FV is the value of the investment when it reaches maturity, and the Type indicates whether the payments are due at the end of a period in which case, the value is zero, or you can leave it out, or at the start of the period in which case you put in the value of one. If you are more comfortable seeing all of the values as positive numbers, you can multiply the result of the PV formula by -1. As an example, consider a one year investment where you are asked to pay $9,500 for a return of $10,000 after 12 months.
If you assume you can generate 6% return from risk-free investments, you would create this formula in cell B7. That is =PV for present value, B3, the rate, divided by 12, because we are assuming interest is compounded monthly. B4, the number of periods, but B4 is the number of years, so we need to multiply it by 12, again to account for the number of months. We are not making any payments, so we'll leave the payment argument blank, and we have a target future value of $10,000, which is cell B5.
And we can leave the Type argument blank because we are assuming that all payments will be at the beginning of the period. When we press Return, we see that the present value is $9,400.05. And again, because this calculation represents a cash flow from you as opposed to you, it's expressed as a negative value. So the present value of this investment is $9,400.05, because the asking price is greater than the investment's present value. You should pass on the opportunity.
Evaluating an investment using the Present Value function makes your decisions easier. Once you establish a discount rate, which you and your colleague should reevaluate frequently to account for changes in the market, you can run the numbers and arrive at a clear yes or no decision.
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