By
rearranging the equation to solve for PV, we find that the
answer is RM89 (or, RM100 divided by 1.1236). In other words,
the present value of RM100 received 2 years from today given
an opportunity to earn 6% is equivalent to RM89 in today’s
terms.
- RM89
today would be equivalent to RM100, if we are able to earn
a 6% return over a period of 2 years (compounded annually).
As
demonstrated in this example, we can derive the present value
by rearranging the future value equation. The present value
equation can therefore, be stated as:
PV
= FVn / (1 + r)n
And,
as such, the present value in our example, is calculated as:
PV = RM100 / (1 + 0.06)2 = RM89
How
can the present value of a future sum of money (FVn), say
RM100 be increased?
| 1) |
By
lowering the interest rate used, the present value of
a future sum can be increased. In our example, if the
interest rate used were 5% (instead of 6%), then the present
value of RM100 to be received in 2 years’ time would
be RM90.70 instead of RM89. This is calculated as RM100
divided by (1.05)2. |
| |
|
| 2) |
The
present value of RM100 to be received would be higher
if the time period was shortened. Assuming that the interest
rate remains the same (that is, 6%), the PV of RM100 to
be received one year from today would be RM94.33, which
is higher, compared to 2 years (RM89). This can be calculated
as RM100 divided by (1.06)1. |
The
present value relationship (that is, at different interest
rates, and periods) can be depicted in the following graph.
Present
value relationship
 |
