Present Value of a Single Cash Flow | CFA Level 1
Welcome back, fellow finance enthusiasts! Previously, we covered the future value of a single cash flow. Now, it’s time to switch gears and dive into the present value (PV) of a single cash flow. We’ll also examine how various compounding frequencies impact our calculations. Buckle up and let’s get started!
Cracking the Present Value Formula
PV = FV / (1 + r)^n
- PV is the present value
- FV is the future value
- r is the interest rate per period
- n is the number of periods
Let’s use this formula to solve our previous $1,000 goal example:
How much should you deposit today to have $1,000 in 2 years, given a 5% fixed interest rate?
Plug in the future value ($1,000), discount rate (5%), and time periods (2) into the PV formula, and voilà! You need to deposit $907 today to achieve your goal.
Using the Present Value Formula in Real-Life Scenarios
Now that we have the formula, let’s apply it to a few examples involving different compounding frequencies and scenarios.
Miguel’s liquid asset: $424,098 (discounting $1M by 9 years at a 10% discount rate)
Semi-annual compounding: $905.95 (deposit today to have $1,000 in 2 years, with a 5% annual interest rate compounded semi-annually)
Dante’s wedding savings: $16,085 (saving for a $20,000 wedding in 3 years, with an 8% interest rate compounded quarterly)
By rearranging the future value formula, we’ve uncovered the present value formula that can help us determine how much we need to deposit today for various goals. Remember to adjust the interest rate (r) and the number of periods (n) based on the compounding frequency. Keep practicing, and stay tuned for our next lesson on Time Value of Money functions. Happy studying!