Suppose you want to buy a car valued at $750,000 in 15 years, and the prevailing interest rate is 5.5, how much do you have today in order to buy the car in 15 years?
This is what we call Present Value. It is the current value of future cash flows discounted at the appropriate discount rate. It is calculated by dividing the Future Value (expected amount in the future) by the Discounting Factor.
This value means that given that interest rate is constant 6.5% over 15 years, we will earn 10,000 if we have 3,888.265 to invest today.
To calculate the present value, we need to determine the discounting factor. The discounting factor is calculated using the formula:
Discounting Factor = (1 + Interest Rate)^(-Number of Years)
For this example, the interest rate is 5.5% and the number of years is 15.
Discounting Factor = (1 + 0.055)^(-15)
Discounting Factor ≈ 0.432999
Now we can calculate the present value by dividing the future value (in this case, $750,000) by the discounting factor:
Present Value = Future Value / Discounting Factor
Present Value = $750,000 / 0.432999
Present Value ≈ $1,731,602.50
Therefore, in order to buy the car valued at $750,000 in 15 years, you would need approximately $1,731,602.50 today.