Calculating the present value of an investment enables you to answer the question of how much a proposed investment is worth in today’s dollars. You can answer that question using the PV, or present value, function.
- [Instructor] Calculating the present value of an investment enables you to answer this question. How much is a proposed investment worth today? You can answer that question using the PV, or present value function. I'll demonstrate how to perform this calculation using the present value workbook. You can find it in the chapter one folder of the exercise files collection. To calculate the present value, you need to know several bits of information. The first is the annual interest rate, which I have in cell B3. We're assuming it's 5%.
When we perform our calculation, I'm going to assume that interest is compounded monthly, so we'll need to divide the rate by 12. The number of periods is 120 and because again we are assuming that we have monthly compounding, that means it's 120 months or 10 years. Payment is in the ongoing payment. That would go into the investment. In this case we're assuming it's zero, and then the future value is what we are going for as an investment goal. Either payment or future value can be zero, but both cannot be.
If you don't have a payment, you must have future value and vice versa, though of course you can have positive values in both of those arguments. Type indicates when interest is compounded. It can either be at the end of a period, which is zero, which is also the default, or it can be one, which means that interest is compounded at the beginning of the period. That's very rare, but you might run into that circumstance. With that background in place, let's create our formula. In cell B9 I'll type equal and then PV, followed by a left parentheses.
The rate is in B3 and again we're compounding monthly, so we need to divide that by 12. Comma, the number of periods is in B4, and again that's 120 months or 10 years, then a comma. The payment, which in this case is zero, is in B5, comma, then the future value, which is the amount of money that will be in inflow to our account, so it's a positive number, is in B6, comma, and then we're assuming type zero at the end of a period for interest compounding, so I will click B7, type a right parentheses and enter, and I see a value of $91,074.16.
The reason that the value in B9 is red and a negative number is because that is the amount that we are expected to pay, so it's an outflow from our account. The value in B6 is an inflow to our account, so it is a positive number. If you would prefer to see present value as a positive number, you can multiply the result of the formula in B9 by negative one and get a result that is more to your liking. Evaluating an investment using the present value function makes your decisions easier.
Once you establish a discount rate which you and your colleagues should reevaluate frequently to account for changes in the market, you can run the numbers and arrive at a clear yes or no decision based on how much you are expected to pay for an investment.
- Calculating the effect of interest rates and inflation
- Finding the arithmetic and geometric means of growth rates
- Calculating the future and present value of an investment
- Calculating loan payments for a fully amortized loan
- Calculating the effect of paying extra principal with each payment
- Finding the number of periods required to meet an investment goal
- Calculating net present value and internal rate of return
- Building a cash tracking worksheet
- Visualizing cash flows using a waterfall chart