One of the most valuable additions to a savers toolkit is the present value calculation. Even though it comes off as a bit scary at first, the amount of value it creates as a tool for understanding our financial position by putting the numbers right in front of us. By using the present value function, we can then start to look at how it is that our future obligations and investments impact us today.
The present value equation looks at money that we will be receiving at a later date, and tells us how much that amount of money is worth to us today. From there, we can compare the different aspects of our financial position to find out which obligation should take on a higher priority to pay off first, or which investment is worth more to us in the longer term.
To calculate the present value of a payment schedule, we need to know the number of payments that will be made/received, the number of periods in which we will receive these payments, and the interest rate under which these payments will be operating. From there, we multiply the dollar value of the payments by the inverse of the interest rate, less the interest rate multiplied by its full percentage amount, to the power of the number of periods in which we will receive/pay those payments. Don’t let the verbal explanation confuse you, it’s much simpler when you see it symbolically: Continue reading