Present value describes how much a future sum of money is worth today. Three most influential components of present value are : time, expected rate of return, and the size of the future cash flow. The concept of present value is one of the most fundamental and pervasive in the world of finance. It is the basis for stock pricing, bond pricing, financial modeling, banking, insurance, pension fund valuation. It accounts for the fact that money we receive today can be invested today to earn a return. In other words, present value accounts for the time value of money.The formula for present value is:PV = CF/(1+r)n Where:CF = cash flow in future periodr = the periodic rate of return or interest (also called the discount rate or the required rate of return)n = number of periodsExample :Assume that you would like to put money in an account today to make sure your child has enough money in 10 years to buy a car. If you would like to give your child 10,00,000 in 10 years, and you know you can get 5% interest per year from a savings account during that time, how much should you put in the account now? PV = 10,00,000/ (1 + .05)10 = 6,13,913/-Thus, 6,13,913 will be worth 10,00,000 in 10 years if you can earn 5% each year. In other words, the present value of 10,00,000 in this scenario is 6,13,913.
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