How to Calculate Present Value of an Investment: Formula & Examples

How to Calculate Present Value of an Investment: Formula & Examples
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  • 0:00 Present Value Formula Defined
  • 0:29 Formula
  • 2:17 Another Example
  • 3:37 Lesson Summary
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Lesson Transcript
Instructor: Michael Cozad

Michael is a financial planner and has a master's degree in financial services.

This lesson will provide an overview of how to calculate the present value of an investment. Various examples will also be explored using the present value formula. You can test your knowledge of the material with a quiz at the end of the lesson.

Present Value Formula Defined

Have you ever dreamed of paying cash for a new car, covering all of your children's college education or leaving an inheritance for your heirs? Maybe you have an idea of how much your goals will cost but just don't know how much to save today. The present value formula can help you calculate how much to save now in order to reach a certain level at a predetermined date in the future.

Formula

Imagine our fictitious client, Dr. Jeff Fox, has just had a daughter. Dr. Fox is a family physician and understands the importance of saving. He wants to set up an inheritance account for his daughter. By the time she is 20, he wants to have $100,000 saved for her to give to her for her birthday.

The present value formula can help Dr. Fox in determining how much money he should set aside today to reach his goal for the future. Dr. Fox believes he can earn 5% per year in compound interest, or interest that builds on the principal and increases in value. Our formula to calculate present value is:

PV = X / ((1+r)^n)

PV = present value

X = future value required

r = periodic rate of return

n = number of periods

In the case of Dr. Fox saving for his daughter's future, the variables are:

PV = present value

X = $100,000

r = 5%

n = 20

We can then fill in the present value formula as follows:

PV = X/((1+r)^n)

PV = $100,000 / ((1+5%)^20)

PV = $100,000 / ((1.05)^20)

PV = $37,688.95

The present value formula shows that if Dr. Fox sets aside $37,688.95 today, he can reach his goal of having $100,000 for his daughter at age 20 if he earns a 5% compound annual rate of return.

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