is the value of today’s money of an amount of money in the future.
The background for this concept is that if you are given a choice of $500 today and $500 after 5 years, naturally, any rational man would choose to take the money today. It is because of the fact that $500 taken today will be worth more than $500 after 5 years.
The reason is, if you take the money today and invest it in bank which gives 10% of interest pa. So, after five years the original $500 will become $500*10/100*5= $250. So, after 5 years the amount of $500 today will be worth $750 (Principal $500 + Interest $250).
The Theory is that when the interest rate is higher the Present Value will be less. Here, in the above example we can see that the interest is 10% p.a. and half of the principal gets added up to the principal.
If in the above case if the interest is say 15%, then, the amount received finally will increase more given the time is constant In both cases. $500*15/100*5 = $375. If the interest rate is 20% then the amount will double after 5 years as $500*20/100*5 = 500.
The formula for calculating Present Value is P = F / (1+r)n, where P is the Present value, F is the Future value and r is the rate of return and n is the number of years.
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