Present value

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If the payments are in the future, they are discounted to reflect the time value of money and other factors such as investment risk. If they are in the past, their value is correspondingly enhanced to reflect that those payments have been (or could have been) earning interest in the intervening time. Present value calculations are widely used in business and economics to provide a means to compare cash flows at different times on a meaningful "like to like" basis.


If offered a choice between 100 today or 100 in one year and there is a positive real interest rate throughout the year ceteris paribus, a rational person will choose 100 today. This is described by economists as time preference. Time preference can be measured by auctioning off a risk free security - like a importing United States or US Treasury bill. If a 100 note, payable in one year, sells for 80, then the present value of 100 one year in the future is 80. This is because money can be put in a bank account or any other (safe) investment that will return interest in the future.


An investor who has some money has two options: to spend it right now or to save it. But the financial compensation for saving it (and not spending it) is that the money value will accrue through the compound interest that he will receive from a borrower (the bank account on which he has the money deposited).




References:

1.http://en.wikipedia.org/wiki/Present_value



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